Style drift has become shorthand for freelancing fund managers buying whatever the heck they want. Craig Callahan of ICON Funds says this is a misconception.
Craig Callahan knows his views on style drifting are not popular, and that's just fine with him. The chief investment officer at Denver-based ICON Advisors believes the current practice of keeping investment managers in “boxes,” limiting managers to small-cap stocks, or large-cap stocks, or whatever is their “specialty,” is outdated, foolish and exists out of convenience rather than logic. He spoke to Registered Rep. staff editor Will Leitch about the benefits of removing constraints on managers.
Registered Rep.: You have been a rather lonely voice in favor of style drift. Why do you think it's effective?
Craig Callahan: The key is reminding yourself of the difference between investing style and investing characteristics. “Characteristics” refers to market caps and the like, and “style” is just a method of investing. There's no such thing as small-cap value “style,” that's a characteristic. Same thing for large-cap “style.” It's possible for a manager to stick to his style, but characteristics will change and drift through time. You cannot look at what a manager is holding and say that they have style drifted.
Our research shows that locking managers in boxes costs portfolios about 300 basis points a year in performance. It's a terrible system. We call it constrained investing. It's constraining a manager to specific characteristics. And it doesn't work.
When we rigidly test certain styles of investing, it becomes apparent that you want a manager's favorite picks, their 20 to 40 best picks. Once you get out beyond their 60th or 80th favorites, you lose any benefit that goes with that style. You want their best stuff. But a manager's best stuff doesn't always fall in one box. When you lock a manager into one box, you're not getting their favorite picks. You're getting less than what you want. You want their style; you shouldn't care what the characteristics are.
RR: Why do you think most people are so resistant to the concept?
CC: When we present it to consultants, about a third agree with us, a third don't like it but they're open-minded about it and about a third won't even listen, because it threatens their way of life. They're putting their desire to control things ahead of performance; it's an ego deal, really.
It's a shame too, because consultants and advisors could handle more clients and be more prosperous if they weren't spending time being a policeman over managers. What we're proposing is a very good business model for advisors and consultants. It leads to selecting managers who have to stick to their style but are allowed to switch characteristics.
What's really interesting is that when we looked for the historical precedent for why the current system was established, we couldn't find it. There was no empirical basis for it. There was no article or research that said this is a good system that works; it just evolved out of convenience.
RR: Do you think this is something that will ever become more popular? Is this something that could go mainstream?
CC: I've been an active advocate of this for five years, and it used to be that no one would listen, but it's getting more and more prevalent over the last two years. That system didn't protect people in 2000 and 2001, so that system is more vulnerable to criticism than it was in the easy-to-make-money ‘90s. It's a terrible system that was tolerated because of the great markets of the ‘80s and ‘90s.
Consultants sticking to the old system will lose business, and those with an unrestrained system will gain business. I don't have to change the system; the free market will speak.
What people now call the style grid will be obsolete in 10 years. Those who don't get with the program will fail, or whatever results from underperformance. Even if litigation comes up, trustees and consultants would be in a world of hurt trying to defend use of constrained investing.