Think Outside the Style Boxes

Identifying the strategy of U.S. and international active equity mutual funds is accomplished by gathering "Principal Investment Strategies" information from each fund's prospectus (SEC-mandated, 1998) which is input into a strategy identification algorithm.  This algorithm has been fine-tuned using an iterative process involving manager interviews, gathering principal strategy information, eliminating keywords that generate false signals, and settling on a manageable number of strategies.

Over the last 10 years, tens of thousands of pieces of strategy information have been gathered for the 3,000 or so (ignoring share classes) U.S.-based active U.S. and international equity mutual funds. The identification algorithm assigns specific strategy information to one of 40 elements (i.e. the specific things managers do to implement their strategy), which are then assigned to one of 10 equity strategies. The ten equity strategies are listed below.

For example, Competitive Position managers focus on business principles, including quality of management, market power, product reputation, competitive advantage, sustainability of the business model and history of adapting to market changes. Economic Conditions managers take a top-down approach based on economic fundamentals. And so forth for the other eight strategies. Those that believe equity managers deviate from their stated investment approach and therefore question the value of self-declared strategy should review my working paper that summarizes the initial test results.  

The strategy database is updated monthly and has captured data starting from 1980. This is a self-identification process, so the number of funds varies across strategies.  Summary strategy benchmark statistics are provided below.

Applying a Strategy Framework

Clustering managers based on their self-declared strategy helps avoid the problem of comparing funds that are actually pursuing very different investment approaches.  Other benefits include:

• Managers are free to pursue their stated investment strategy.
• Managers following similar investment processes are grouped together.
• Strategy-based peer groups remain stable over time, allowing for long-term comparisons.
• Returns are more correlated within strategies and less correlated across strategies.

Once the universe is organized this way, useful applications begin to appear.

• Strategic and tactical portfolio construction based on strategy can be implemented.
• Managers can be ranked by their consistency and conviction.
• Stocks held by strategy peer groups can be identified.
• Expected returns based on market preferences for strategies can be calculated.

The strategy framework also helps to diversify an equity portfolio beyond capitalization and PE, improving diversification with strategies that have different performance patterns. If portfolio managers prioritize the pursuit of their strategy above style grid categorization, and do so consistently, financial advisors and investment consultants are able to select funds and build portfolios with better characteristics and designed to work well in a range of market conditions.

Lastly, as outlined in this study, the consistent pursuit of a narrowly defined strategy, as well as taking high-conviction positions in the manager's best ideas, is the path to superior fund performance.

The New Foundation: An Intelligent Organization of the Markets

The concept of investment strategy is widely known and discussed in the industry. Strategy is not only an intuitive way of thinking about investment management, but also provides a superior framework for understanding investment markets in general.

I refer to this as an intelligent organization. It is intelligent because it is based on the strategies being pursued by thousands of active equity managers, each attempting to earn superior returns by consistently pursuing a distinct strategy. It is dynamic and driven by the collective intelligence of thousands of highly resourced active managers.  This contrasts with the limited characteristic-based frameworks such as the style grid.

A strategy-based approach yields a clearer picture of the markets and, in turn, investment management. The resulting framework can be used to organize, rate and view managers; build and manage portfolios; and evaluate investments and markets. We will further explore these activities in future articles.

— More by C. Thomas Howard:

• Portfolio Management in the Active Equity Renaissance
• Behavioral Finance Is a Promising Alternative to MPT

C. Thomas Howard is the CEO and chief investment officer at AthenaInvest and a professor emeritus at the Reiman School of Finance, Daniels College of Business, University of Denver. He can be reached at [email protected].