Equity managers are commonly hired to represent a particular "style" box that limits them to picking stocks with certain characteristics, like small-cap value or large-cap growth. An extensive literature search reveals that this system has no empirical basis, however, but simply evolved out of convenience. Along the way, assumptions essential to its validity were made and believed to be true without empirical support. In using the multi-specialist system, the words "style" and "characteristic" are currently used synonymously. We would distinguish between the two and argue that small-cap value, for example, is neither a style of investing nor an asset class, but is simply a box in the characteristic grid. In order to produce superior returns, managers must be allowed to pursue their unique styles and have access to the entire equity universe, which means that their resulting portfolios experience characteristic drift. Furthermore, based on style constancy, our empirical results show that characteristic-constrained investing sets the stage for underperformance.
In a style grid, stocks are ranked vertically on a market capitalization scale as small cap, mid cap, or large cap, and ranked horizontally on a value-growth scale. This grid is often incorrectly referred to as the style grid. It has become the basis for a very popular way for institutions to manage money: Multiple managers are hired and each one is generally required to buy and hold stocks from a single box, for example, mid-cap value.
Institutions undertake this approach in the belief that a manager can specialize in a particular box. At the overlay level, the weightings assigned to each box are set by the investor and can change through time or be left constant. We call this system "characteristic-constrained investing," as managers are constrained to boxes defined by market capitalization and value-growth characteristics. We refer to the traditional style grid instead as the "characteristic grid" as shown in Chart 1.
A foundation of the characteristic-constrained system is the assumption that "style" and "characteristic" are synonymous. Small-cap value, for example, describes a characteristic: stocks with small market capitalizations and low price/earnings ratios, price-to-book value, or price-to-sales ratios. Hence, stocks in that box are referred to as small-cap value and managers may categorize themselves as small-cap value managers.
Style and characteristic are not synonymous, however. The term "style" refers to a system, methodology, or technique of selecting stocks. It is the manner in which a manager screens stocks for selection. "Characteristic" refers to the market capitalization and value-growth scales. Small-cap value or large-cap growth does not describe the style that a manager employs when buying and selling stocks; each simply describes characteristics.
Characteristic-Constrained Investing
A literature search on characteristic-constrained investing revealed no inaugural article or empirical basis for the approach. It has evolved out of convenience and was partially driven by the desire to shift performance determination from the manager to the investor. Many advisors and consultants adopted the system for its ease and simplicity and for the opportunity to affect returns by determining the portfolio market capitalization and value-growth characteristics of the resulting portfolio. Along the way, this system has never been challenged. It evolved based on assumptions that have become accepted as truisms. Under empirical investigation, however, the assumptions supporting the use of characteristic-constrained investing fail, rendering the system defective. These are the key assumptions:
One box. For the system of constrained investing to be successful, a manager's best stock selections, made through the rigid application of an investment style or technique, must fall into one box. Our research shows that this assumption is not valid and that a manager's best selections do not fall into just one box.
No Migration. The second assumption that has been made, and that is necessary for constrained investing to be successful, is that the stock selections made by the rigid application of an investment style over time do not migrate to other characteristic boxes. Adding to the first assumption–that a manager's best stock selections fall into one box, for example, small-cap growth–those best selections must not appear in other boxes in different time periods.
Hurts Performance. The third and final assumption necessary for characteristic-constrained investing to be successful is that characteristic drift by managers hurts performance. In implementing the constrained investing system, managers are required to hold stocks from just one characteristic box and can be terminated for drift. Our research shows that characteristic drift not only does not hurt performance but is part and parcel of superior performance.
Russ Wermers of the University of Maryland, in an unpublished 2002 paper, A Matter of Style: The Causes and Consequences of Style Drift in Institutional Portfolios, combined two databases to create a single mutual fund performance and portfolio holdings database. He ranked managers by drift and performance and found a strong inverse correlation: Managers who had portfolios with the greatest characteristic drift had annual alphas nearly 300 basis points higher than those managers with the least drift.
Study Methodology
The methodology in our study examined the three assumptions necessary for constrained investing to make sense (based on our January 2005 working paper, The Problematic "Style" Grid," available at www.iconadvisers.com).
- Stocks selected by a style (technique) fall into a single characteristic box.
- Stocks selected by a style (technique) do not migrate to other characteristic boxes over time.
- Characteristic drift hurts performance.
We tested four styles of stock selection by equity investors that have been published and are easily applied to a universe of stocks: those of Benjamin Graham, John Neff, William O'Neil, and T. Rowe Price. Graham published his Central Value Formula in 1962. It considers earnings per share, a five-year growth rate for earnings per share, and the AAA bond yield. Market price is divided by estimated value, stocks are ranked, and the lowest ranking price/value stocks are favored as they are considered to be the best bargains. The Neff, O'Neil, and Price investment styles compute a score by multiplying a few variables together. Neff includes earnings per share, sales growth rates, and free cash flow. O'Neil considers earnings per share and sales growth rates but also price relative to a 52-week high. T. Rowe Price incorporates earnings yield, return on assets, operating margin, net margin, and earnings per share growth.
Each style was rigidly applied to the Standard & Poor's SuperComposite 1500 index universe at the beginning of each year from 1995 through 2003. To explore the impact of equity style on characteristic drift and investment performance, the stocks in the S&P SuperComposite 1500 Index universe were sorted into one of the nine characteristic boxes shown in Chart 1. The stocks that ended up in the large-cap value box, for example, ranked in the upper third by market value and ranked in the lower third based on price/sales. As a result, the nine characteristic boxes had varying numbers of stocks on average and over time.
Test Results
The first question to be tested is whether the 20 highest-ranked stocks for a rigidly applied investment style fit into just one characteristic box. Notice how this is related to the issue of "style" and "characteristic" either being synonymous or distinctly different. Table 1 shows the characteristic box that each style appeared in most frequently, on average, over the nine annual periods. It is immediately apparent that none of the four styles match with just one box. To the contrary, all four styles select stocks in multiple characteristic boxes. For each of these four approaches, style and characteristic are not synonymous and none of the four fit into just one box.
