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Problems with Categorizing Managers based on Portfolio Characteristics
So if the 74bp is not a reward for risk and the investor or the advisor cannot easily earn this additional return by tilting the portfolio or placing short term style bets, then why change the manager’s benchmark from the S&P 500 to large-cap value? There is no good reason for such a decision. In fact, there are a number of residual problems that are created by categorizing managers based on portfolio characteristics.
Managers are categorized using portfolio holdings or style index returns. But what does this tell you about the strategy being pursued by a manager? The answer is little to nothing. Shouldn’t a categorization system help you better understand the management process? But it is worse than this. Since many investment organizations use style designations for organizing and selling investment products, there is a strong motivation for the manager, once classified, to avoid drifting into another category. Thus is created the conflict between staying in a style box and consistently pursuing a strategy. Unfortunately, many managers choose the former to the detriment of performance. I and others, including Wermers, have documented the decline in performance resulting from a manager hugging an index or staying in a style box. This is the categorization system getting in the way of what a manager should be doing, relentlessly pursuing a well defined investment strategy.
Considering all of this, it begs the question why market cap and PE? There are hundreds of characteristics that could be used to categorize funds. For example, why not categorize funds based on their holdings’ average ROE and earnings yield? The answer is there is no logic. It used to be argued that market cap and PE be used because they had a long term return advantage. But the recent evidence mentioned above throws this argument in doubt. But any portfolio characteristic will run into the same categorization problems as do market cap and PE. So it is time to look elsewhere for a way to think about managers.
Focus on Strategy Instead
Based on research conducted over the last five years, a better way to think about managers is the strategy they are pursuing. Once each manager has been strategy identified, it is possible to form meaningful peer groups. The advantage to this approach is that the manager self-declares a strategy and thus is free to pursue it without having to worry about fitting into a style box. Focusing on strategy avoids the conflict between doing what is right for your investors and doing what is right for selling your products. The manager can then be compared to a homogeneous peer group rather than to an arbitrary style box which always contains managers pursuing a variety of strategies and thus is a questionable basis for creating a benchmark. Focusing on strategy also provides insight into what the manager is doing, unlike the opaque style boxes.
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