In the traditional investment world, it is considered crucial for an active investment manager to stick to their style box. After all, if the manager "drifts" from small cap to large cap, the investor may suddenly find themselves with an under-allocation to small cap, and an excess of large cap, violating their goal of maintaining a well diversified portfolio. Yet there is a growing recognition that for many mutual funds, constraint to a style box may be eliminating the very value that active management was intended to achieve!
The inspiration for today’s blog comes from the website Investius, which conducts video interviews with various thought leaders in the financial services industry. A few weeks ago, Investius interviewed Don Duncan of D3 Financial Counselors in Chicago, about the potential benefits of style box drift. In the brief video interview, Duncan observed that when an active manager is limited to a style box, you’re limiting their opportunities to invest. For instance, if a growth manager is assigned to the small cap growth "box" and is limited there, then the manager could produce poor results for an extended period of time if small cap (or growth) underperforms the broad market, even if the manager is brilliant.
The idea of allowing active managers more flexibility in their investments – what some are calling "free range" investing – is something I have discussed before in this blog. Although frankly, I find even the small cap growth example to be constraining. Imagine instead that you were invested with a brilliant tech fund manager who outperforms his index by a whopping 10 percentage points in a year; if it’s 2000 to 2002, you’re still going to be spectacularly unhappy with the losses that you see. If, ironically, the tech manager was actually so good he saw the disaster writing on the wall, constraining the manager to only the tech sector – or some Morningstar style box like small cap growth – actually removes from him the flexibility needed to sometimes get out of the way of a train wreck he can see coming. This isn’t even just about finding good returns; it could just be about avoiding disasters, if the "style box" options are simply between the style box equity investment, or cash as an alternative.
In truth, our style box constraint challenges are really, at their core, a benchmarking problem. Without the creation of style boxes and the benchmarks that they provide, evaluating investment managers was difficult. If manager A outperformed manager B by 20%, was the difference because manager B selected better investments than manager A? Or was it because the year is 1999, and manager B is a tech manager who is enjoying the tech wave, while manager A is a large cap value manager who is doing a great job in an unloved segment of the market?
Enter the style box – a way to classify managers into subsegments of the markets, so that they can appropriately be evaluated relative to their actual peers. Manager A shouldn’t be compared to manager B; one is a large cap value manager, and the other is a tech fund manager. Instead, style boxes allow us to compare large cap value managers to others of their ilk, and the tech fund is tested against other tech funds that now must demonstrate value relative to their own segment of the market.
Unfortunately, though, what started out as an exercise in benchmarking has become a process of portfolio design. What started out as a way to differentiate the returns of a manager – between the active management value provided, and the headwind or tailwind that may have applied to the manager’s segment of the market – has become a way to box managers in. The reason is actually remarkably straightforward – if I want to own a well-diversified portfolio, where I can check off each of the different boxes for my client as another not-perfectly-correlated investment, I need the fund to stay in its box. Otherwise, my allocation changes, and if I want to remain fully diversified at all times, investment shifts are a problem. Furthermore, performance evaluation challenges arise; if my manager can be in tech stocks today, but something else tomorrow, how do I measure the performance? Against what? Better to keep them in their box, where I know how to evaluate them; if I want another box, I’ll go find a manager who works in that space.
If we constrain the managers too narrowly, though, we risk eliminating their capacity to provide value. The most brilliant manager in the world would have owned tech in 1999, small cap value by 2001, emerging markets by 2005, commodities in 2007, and government bonds in 2008. If it can be done – and I’ll grant it’s an if – the manager who moves nimbly amongst the boxes can outperform the diversified investor who simply holds a little of each. Unfortunately, though, it’s incredibly difficult to evaluate the performance of that manager – against what do you measure as a benchmark, when the manager can travel to all segments of the investment universe? How do you know if they’re actually doing a good job?
Nonetheless, the fact remains – as advisors like Don Duncan observe – that constraining managers to a single box, even if it makes our evaluation and portfolio design jobs easier, limits at least some managers’ opportunity to express their skill. If you’re a fund manager stuck in a style box, you can only generate "so much" outperformance – even if you’re good – with a very limited universe of investment choices. The broader the scope, the more opportunity there is – albeit with a significant increase in the difficulty of measuring performance in the first place.
So what do you think? Do you prefer managers to stay within their style boxes? Do you view "free range" managers as an increased opportunity, or a hazard that clients should avoid? Is style drift bad; or is a management style that goes "outside the box" the best way to go?