Study Proves That Style Consistency Pays

There's no foolproof way to pick mutual funds that consistently outperform, but a University of Texas professor and a Fidelity Investments executive have found a way to at least improve your odds. The strategy they suggest is best summarized thus: Buy funds that stick to their knitting. Keith C. Brown of UT and W.V. Harlow of Fidelity based the advice on their analysis of 3,177 stock funds. They placed

There's no foolproof way to pick mutual funds that consistently outperform, but a University of Texas professor and a Fidelity Investments executive have found a way to at least improve your odds.

The strategy they suggest is best summarized thus: Buy funds that stick to their knitting.

Keith C. Brown of UT and W.V. Harlow of Fidelity based the advice on their analysis of 3,177 stock funds. They placed each fund into one of nine style categories — large-cap value, growth and blend; mid-cap value, growth and blend; small-cap value, growth and blend — and tracked them over a 10-year span (1991-2000). Their finding was conclusive: Funds that stayed faithful to their investment style enjoyed higher returns than funds that roamed all over the style box.

“Do more style-consistent funds outperform less style-consistent funds? The answer is unambiguously yes,” Brown says. “There is value in finding a more style-consistent manager.” Odds are, for example, that a small-cap value fund that sticks to its designation will fare better than a small-cap value fund that strays, say, into the small-cap blend or mid-cap value category.

The style consistency premium was significant over the entire decade encompassed by the study. In some cases, the performance gap was dramatic. Style-consistent large-cap blend and small-cap growth funds enjoyed annual median returns of 20.04 percent and 14.21 percent, respectively, versus 16.69 percent and 12.78 percent for their peer groups.

What's amazing about the study's results is that the style-consistent funds performed better even after the researchers controlled for expenses and portfolio turnover. Why is this significant? Because, up until now, low fund expenses, as well as modest portfolio turnover, were two of the only reliable indicators that you could use to predict future superior performance. But there is an obvious connection: Style-consistent funds are likely to have lower costs because they tend to spend less on trading.

Still, proof of the style consistency premium is big news, says John Rekenthaler, president of Morningstar Associates, a subsidiary of the mutual funds research and ratings company. “This is a surprising result,” he says. “When you look at a mutual fund and control for expenses and turnover rate, style consistency really shouldn't matter.”

Why should style consistency alone have such a payoff? Brown speculates that the managers who remain committed to their little square in the style box are less likely to mess up with their asset allocation and stock picks than those who try to time their style decisions.

This argument makes perfect sense to Arnie Wood, president and CEO of Martingale Asset Management in Boston. “When managers make changes in a portfolio and they leave their particular style, they tend to make more mistakes as they drift,” he observes. “When they drift, they tend to fall into the same trap as individual investors: They run to whatever has done best recently.”

Larry Swedroe, director of research at BAM Advisor Services in St. Louis, suggests the study indirectly makes a strong case for index funds, which are intrinsically style consistent. “We would suspect that index funds would compare favorably, since passive funds would logically have the greatest persistence of style.”

Brown says advisors shouldn't assume, after reading the study, that indexing is the only way to go. “The message isn't that you shouldn't hire active managers and just index,” he said. “We are finding people who are producing reliable alpha, but they are the ones who stick closer to their mandate.” (Alpha refers to any excess performance produced by a manager beyond the market return.)

A single study, however, will not convince skeptics. One obvious question is whether the findings from data gathered in the 1990s boom are conclusive. “What appears to be a truth in one particular market environment, you could find just the opposite happens during the next environment,” Rekenthaler says.

Wood, however, suggests that the study's conclusions “are right on” regardless of the time frame because of the human behavior factor. “Behavior plays such a big part in this; whether it's a 10-year, five-year or 50-year period, behavior is very persistent.”

If the study's findings make sense to you, your next question might well be, “Where can I find these funds?” Unfortunately, the answer is not simple. A recent analysis of funds by Standard & Poor's suggests that most stock funds, over the long haul, are style creepers. During the three-year period ending in 2002, S&P calculated that only 46.3 percent of domestic funds remained true to their style box. Over the past five years, the figure drops to 36.8 percent.

According to S&P's three- and five-year statistics, large-cap value and growth funds were the most likely to stay inside their respective style boxes. By contrast, small-cap and mid-cap blend funds were the biggest style violators.

You may be able to use software at your brokerage firm that can help you pinpoint whether funds are sticking to their stated investment mandate. Such software is offered by a number of companies, including Barra, Ibbotson Associates, Vestek, Markov Processes International, Morningstar and Zephyr Associates. These providers are divided into two camps: those that favor returns-based analysis and those who prefer holdings-based analytics. The returns-based style relies upon historical returns to provide an estimate of the average style position of a mutual fund or separate account during a given period. This software doesn't look at actual portfolio positions. In contrast, holdings-based software analyzes the actual securities within a given portfolio to generate style information.

For those who don't have access to style-analysis software, there's a way to eyeball whether a fund has strayed from its mandate: Consult the print version of Morningstar Mutual Funds. At the top of each one-page analysis, Morningstar pinpoints where the fund has resided within the nine-square style box for each of the past nine years.

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