Failures of the Style Grid

Many advisors, with whom we have spoken over the years, have become disenchanted with the style grid. The general feeling is that there is something wrong, but it is not clear what. It is a kind of general unease with the approach. So what is the problem with the style grid?

AthenaInvest uses the terms style and strategy in a very precise way. Style refers to the average market-cap, P/E characteristics of the portfolio as used by Morningstar and other market participants. Strategy is the way a manager goes about analyzing, buying and selling.

The style grid has grown in importance over the last 25 years as a result of the unrelenting pressure of a leaderless industry stampede, rather than the consequence of carefully conducted research regarding its usefulness. It has become the language of the industry to the detriment of mutual fund managers, advisors, and investors alike.

Style Grid Problems

Non-Unique Peer Groups

The underlying issue is the style box reveals little about how investment decisions are made. For example, what approach is being pursued by a so called “small-cap blend” manager? Does the manager analyze every aspect of the company by visiting the management team, talking with suppliers and competitors, and gauging its competitive strength? Or do they simply run the numbers and never set foot on company property? Are they looking for companies with long-term profit potential or are they simply looking for a short-term arbitrage opportunity? In fact, they could be doing all, some or none of the above and still be included in the same small-cap blend peer group, or any style box for that matter.

Those who have used style box screens recognize the problem of non-meaningful style grid peer group comparisons because they know that managers grouped in the same style box pursue a variety of investment strategies. This problem is compounded by the industry’s subversive habit of co-mingling the meaning of “investment style” and “investment strategy.” While the style grid may have originally been conceived of as a tool to help investors easily determine an investment manager’s strategy by analyzing his portfolio holdings, this simplistic approach has fallen far short of doing so.

Boxes Destroy Performance

But a worse problem is lurking. Managers generate superior returns by pursing a narrowly defined equity strategy. Anything that gets in the way of this pursuit hurts performance. The style grid does just this. Being labeled small-cap blend, a manager has to stay style pure or else be viewed as a pariah by highly lucrative fund platforms. So the manager has to chose between being strategy consistent, which means moving around the equity universe, or stay in a style box and end up purchasing bad idea stocks rather than good idea stocks. Since the financial incentive to raising AUM by being a style grid good citizen far outweighs the loss due to inferior performance, most managers choose to remain in a style box. Style box purity and superior performance are incompatible.

Size and P/E Effects are Non-Exploitable

The underlying P/E and market-cap research, the supposed foundation for the style grid, has turned decidedly against these two market factors in recent years. There is evidence that managers cannot successfully time these two factors, that the small firm effect has morphed into a large firm effect, and that the low P/E effect is absent in those stocks most frequently held by mutual funds. So if it ever made sense to categorize managers based on the stocks held, which it has not, P/E and market-cap are a very poor pair of stock characteristics for building such a system.

The evidence is incontovertible: sticking a manager in a style box hurts performance, building the fund distribution around the style grid forces managers to stay in a style box, and the P/E and market-cap factors are not exploitable by fund managers. It is hard to imagine a more poorly conceived system.

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