Style Importance in Manager SelectionSubmitted by LHD Retirement on April 26th, 2018
By Jess DeGabriele
A sometimes-overlooked tool in the advisor and plan sponsor’s analytical toolbox is investment manager style. Style is used to help segment different asset classes and investment managers into comparable subgroups, such as labeling a growth manager as “growth” as opposed to “value.” The objective of placing different managers into style groups is to assist in building diversified portfolios that are exposed to return factors from many different sources, and using the style group to compare managers and determine talent. Style simplifies these tasks.
The most common way to think of style is with equities, where style factors have been studied extensively and should be most familiar, notably in market capitalization and investment strategy, such as growth, value, or taking a market-oriented approach to portfolio construction. These different equity styles have been popularly represented by Morningstar’s 3x3 style box.
Style is measured in several ways, with holdings-based the most often used. Holding-based analysis identifies the attributes that make up a style, such as price-to-book ratio, earnings growth, and market capitalization, aggregates these attributes at the portfolio level, and assigns the style. The key is that different styles have different factors of return and each piece can contribute to a diversified portfolio. However, that contribution to diversification is only true if the investment is true to its style, which is why a study of style is important.
When an investment deviates from its typical style, such as when a growth manager purchases value stocks, this is known as style drift. This style drift is detrimental because it makes controlling risk and understanding where and how a portfolio is allocated difficult. If an investment manager goes outside of their mandate, it can shift the risk and sensitivities of a portfolio dramatically. Consider also that regulations require mutual funds to disclose their holdings quarterly, which means that a portfolio could shift without the investor ever knowing. Investment managers that take style seriously and adhere to their mandates are necessary for effective portfolio management.
Style also helps in the investment manager due diligence process. For the managers that adhere to their mandate from a style perspective, the determination of manager skill and talent becomes a bit more intuitive. This is because certain style factors can outperform the broad market for long periods of time. How do advisors and plan sponsors differentiate between investment manager talent and simply an advantageous market environment for a management strategy? By dissecting the market into styles, advisors can choose an index to benchmark and zero in on the standard investment due diligence methods that can effectively monitor and compare managers. Remember that benchmark indices utilize their own attributes and factors when determining style, so choose a benchmark index that closely aligns with the attributes you’d like associated with a style.
Style analysis can seem arbitrary at times, but it is immensely useful in the investment manager due diligence, selection, and monitoring process. While not perfect, style can be used to inform manager analysis across asset classes.
Jess DeGabriele, CRPS®, is an Investment Strategist with LHD Retirement. He can be reached at email@example.com.
Investing involves risks, including the loss of principal. There is no guarantee that a diversified portfolio will enhance overall returns or outperform a non-diversified portfolio. Diversification does not protect against market risk.
This information was developed as a general guide to educate plan sponsors, but is not intended as authoritative guidance or tax or legal advice. Each plan has unique requirements, and you should consult your attorney or tax advisor for guidance on your specific situation. In no way does advisor assure that, by using the information provided, plan sponsor will be in compliance with ERISA regulations.
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