Style Boxes Won't Die, but They Should

By Scott A. MacKillop | Featured in FundFire

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On April 9, FundFire ran a Your Q&A article by Tim Barron, CIO of institutional consultancy Segal Rogerscasey, which addressed whether styles boxes are falling out of favor. Barron said that style boxes are a useful tool that will be with us for some time to come. I take issue with a number of his points and suggest that, given the way they are used today, style boxes do more damage than good.

The first problem is the way they are used to enforce the parameters of an asset allocation strategy. The common practice is to develop an asset allocation strategy and then fill the “pie slices” with managers that have been categorized using style boxes such as large-cap growth, small-cap value and so forth. We then punish the managers for the sin of style drift based on the assumption that rigidly maintaining the precise allocation among the asset classes is more important than allowing skilled managers to pursue opportunity where they find it.

The fallacy in this is the assumption that the asset allocation strategy is some kind of magic formula, the integrity of which must be maintained at all costs. However, an asset allocation strategy is only as good as the inputs we use to derive it. In fact, those inputs are no more than educated guesses about the future. We don’t know what the future returns, volatilities or correlations of any of the asset classes will be, so our strategy is always flawed to some extent.

Rather than pretending our asset allocation strategies have a precision they simply do not have, we would be better off allowing our managers to “drift” when they believe it is in their clients’ best interest. These managers were hired because of their skill. Why not let them use it? Would you tell Willie Mays, one of the greatest centerfielders of all time, to stay out of left field if he saw a fly ball heading that way? No, you’d want him to try to catch it.

Barron warned of the “risk from style drift” and identifies two components of this risk. The first is the risk that managers will invest outside the “pond in which they fish” and instead invest in “multiple ponds.” He states that allowing managers to do this “presumes expertise in those varied bodies of water” that managers simply don’t have.

The first problem with this is that, clearly, many managers do have skill fishing in “multiple ponds.” There are many examples. Research by professors Martijn Cremers and Antti Petajisto, both of the Yale School of Management, supports the idea that stock-picking skill is indeed transferable from pond to pond.

More fundamentally, the “multiple ponds” argument fails because, for the most part, managers do not think or behave in terms of “ponds,” which are a creation of the consulting industry. Again, the Cremers and Petajisto study makes this clear. Of course, there are managers who do fish in a single pond, but that is probably more to gain the favor of those who look at the world using style boxes as their frame of reference than because it makes good investment sense.

Barron also suggested that style drift poses a risk because it makes measuring manager performance more difficult. This idea turns things upside down. We should first encourage managers to do everything in their power to accomplish the objectives of our clients, including looking for opportunities in multiple ponds. Then, we can worry about how to measure their performance.
We should not restrict managers in their quest to identify good opportunities for our clients in order to make life easier for those charged with measuring performance.

Scott A. MacKillop is the president of Frontier Asset Management, a firm that constructs and manages portfolios for financial advisors and their clients.  He is a 36-year veteran of the financial services industry. He can be contacted at smackillop@frontierasset.com.