The Uses and Misuses of the Style Box

Fixed Income Style Box

During the dot-com boom, managers stretched or abandoned their mandates in droves to buy hot stocks. Like a morality tale, the popping of that bubble punished the dissolute and rewarded the faithful few. Investors learned to keep managers on a tight leash, lest they chase fads like dogs chase cars. Significant shifts in portfolio characteristics, such as large-small or value-growth in equities and duration and credit in bonds, also called style drift, came to be seen with suspicion. Investors began to care a lot about style-box purity.

The consequences of the widespread adoption of style-box investing have been mostly salutary. Active funds are now compared to more-relevant peers and benchmarks. By sticking to well-defined styles, funds have become easier to benchmark. They’ve also moved further away from market-timing to security selection. 

However, the style box’s ease of use and wide adoption have inevitably created problems. Let’s start with something relatively innocuous: the definition of value investing. In its original sense, value investing—better described as intrinsic-value investing—is about buying assets at prices substantially below the sum of their discounted future cash flows. Value can be found in the balance sheet or in growth prospects, so it’s absolutely possible for an avowed value manager to have a portfolio located deep in the growth side of the style box, as with Sequoia (SEQUX, a fund in the US). In the style-box sense, value investing is about buying assets cheap on common valuation ratios. These two notions of value have historically overlapped. Ben Graham, father of value investing, used simple screens to identify cheap stocks, such as net-nets, companies selling for below their conservatively estimated liquidation values. Graham’s greatest disciple, Warren Buffett, made lots of money using these rules in his early days as an investor. However, over time he came to favor quality stocks—growth or blend stocks in the style-box perspective—as his assets grew and slam dunks like net-nets all but disappeared. In his 2000 letter to Berkshire Hathaway BRK.B shareholders, Buffett wrote, “Market commentators and investment managers who glibly refer to ‘growth’ and ‘value’ styles as contrasting approaches to investment are displaying their ignorance, not their sophistication.” Unfortunately, the distinction between intrinsic value and style-box value is now hopelessly muddied in the minds of many investors.

I’d go as far as to say it’s perverse to expect intrinsic-value stock-pickers to stick to a style. The style box is an application of the Fama-French three-factor model, where the three main characteristics that predict stock returns are market, value, and size. In the Fama-French worldview, value and small-cap stocks have higher returns as compensation for their distinct risks. Targeting specific areas of the style box is a blunt way of targeting value and size factor exposures. It’s no surprise the style box does not fully describe the great stock-pickers’ philosophies. Oakmark (OAKMX, a fund in the US) under Bill Nygren went from a mid-cap value fund in the late 1990s to a large-blend fund in the early 2000s, where it has stayed to this day. Nygren shows how a disciplined investor can move around the style box over time, particularly when cheap stocks become concentrated in a sector, as in the late 1990s.

A more insidious consequence of the rise of the style box is the homogenization of fund managers. Since they’ve been forced to be much more conscious of their style benchmarks and peers, many diversify away their active bets and effectively hug their benchmarks. So while fund fees have come down over the past decade, active bets have arguably gone down just as fast—if not faster. Finance researcher Antti Petajisto documents that closet indexing rose markedly in the late 1990s and has stayed there since.

This is bad; more-selective managers tend to outperform. Petajisto found that stock-picking managers who deviated from their benchmarks subsequently tended to outperform closet indexers, before and after fees. Finance professor Russ Wermers found that managers who picked stocks as if they were unconcerned with style drift tended to have superior future stock-picking performance.

There are a few reasons this might be. More-active managers effectively charge less for their services. A simple way to see this is to imagine a fund manager who collects a 1% fee on assets, plunks half of his portfolio into an S&P 500 fund, and uses the rest to make his picks. Because getting market exposure is almost free, he’s charging 2% on the active portion of his portfolio. Obviously, a manager who charges more has a harder time outperforming. But this can’t be the whole story, because more-active managers outperform before fees. Selectivity may signal a manager’s self-assessed ability. A bad manager who knows he doesn’t know much will stick to the benchmark to avoid getting fired; a good one confident things will work out in the long run will be more tolerant of the short- and medium-run pain that often comes with deviating from the market. Finally, selective managers may also concentrate more capital on their best ideas.

The biggest misuse of them all, I believe, is treating the style box as a guide to manager diversification and risk control, as if manager selection were a paint-by-number exercise. A common misapplication is to hire a different manager to fill out each square, in the belief that doing so will produce smoother outperformance. Skilled managers are hard enough to find that it would be strange to first restrict yourself to one manager in each square. If you find two managers with distinct philosophies and holdings who just happen to be in the same style, there is no good reason to dump one in favor of an inferior manager in another area. Neutralizing your portfolio’s overall style tilt is easy with index style funds; finding skilled managers is hard. Filling in squares with specific managers is another way to pay a lot of money to recreate the market.

Properly used, the style box is a useful, intuitive measuring stick. But with widespread misunderstanding and abuse, it’s taken on the aspect of shackles. Investors expect their managers to fit into neat little boxes. Managers oblige and handicap themselves by playing the great sport of investing with their eyes on the scoreboard, not on the ball. There is a simple remedy to these problems: Treat the style box as a crude simplification of a messy reality. Understand that the style box’s definition of value investing is based on an academic interpretation of markets, which in many cases is incongruous with the practitioner’s commonsense focus on intrinsic value. In fact, be suspicious of managers who are not willing to acknowledge these messy realities and timidly stick to their style boxes; such managers are often offering repackaged index funds and probably aren’t all that confident in their own ability to outperform. And whatever you do, don’t obsess over diversifying your active manager picks across the style box, because you can do that much more cheaply yourself. Focus on finding the best managers, regardless of their style tilts, then reshape your overall portfolio’s style tilt with cheap style index funds.