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Getting All the Pieces of the Puzzle
Ron Surz
December 30, 2008

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One form of style analysis is returns-based style analysis (RBSA).  RBSA regresses a manager’s returns against a family of style indexes to determine the combination of indexes that best tracks the manager’s performance. The interpretation of the “fit” is that the manager is employing this “effective” style mix, because performance could be approximately replicated with a blend of passive indexes.

Another approach, called holdings-based style analysis (HBSA), examines the stocks actually held in the investment portfolio and maps these into styles at points in time. Once a sufficient history of these holdings-based snapshots is developed, an estimate of the manager’s average style profile can be developed and used as the custom benchmark. HBSA, like normal portfolios, starts at the individual security level and both examine the history of holdings. The departure occurs at the blending. Normal portfolios blend stocks to create a portfolio profile that is consistent with investment philosophy, whereas HBSA makes an inference from the pattern of point-in-time style profiles and translates the investment philosophy into style.

The choice between RBSA and HBSA is complicated and involves several considerations. Although RBSA has gained popularity, this doesn’t necessarily mean that it’s the best choice. The major trade-off between the two approaches is ease of use (RBSA) versus accuracy and ease of understanding (HBSA). RBSA has become a commodity that is quickly available and operated with a few points-and-clicks. Some websites offer free RBSA for a wide range of investment products. Find the product, click on it, and out comes a style profile. Offsetting this ease of use is the potential for error. RBSA uses sophisticated regression analysis to do its job. As in any statistical process, data problems can go undetected and unrecognized, leading to faulty inferences. One such problem is multicollinearity, which exists when the style indexes used in the regression overlap in membership. Multicollinearity invalidates the regression and usually produces spurious results. The user of RBSA must trust the “black box,” because the regression can’t explain why that particular blend is the best solution. In his 1988 article entitled “Determining a Fund’s Effective Asset Mix”, Nobel laureate Dr. William Sharpe introduced RBSA and set forth recommendations for what has come to be known as the “style palette”:

“It is desirable that the selected asset classes be:

  • mutually exclusive (no class should overlap with another)
  • exhaustive (all securities should fit in the set of asset classes)”

Surz indexes2 are one of only two index families (the other is Morningstar) that meet these important criteria, and are the preferred choice of Dr. Sortino in his groundbreaking work. Surz indexes were the first on the scene, introduced in 1986. Morningstar followed more than a decade later in 1997.

Treating all managers as index huggers is an evaluation mistake. We need to bring the best custom benchmark to each liberated manager, rather than force these square pegs into round holes. Otherwise, we will miss a lot of talent. Some investment firms are simply at their best when left unfettered from indexes. This doesn’t take these firms off the benchmark hook; it customizes the hook.

The investment manager research and due diligence industries have been lazy and sloppy with their benchmarks, tolerating the obfuscations of investment relationship personnel. What we allow in this high stakes game we encourage, at the clients’ expense. Flawed benchmarks lead to flawed decisions.

This manager-in-a-box approach produces flawed asset allocations. Since many managers don’t belong in a box, the allocations to styles get distorted. If the intention is to allocate a percentage of assets to the large growth segment of the market and a single manager is assigned to that segment, we should be sure that the manager is 100% pure large growth.


The challenge in solving the portfolio construction puzzle is defining the puzzle pieces. Current practices, such as shoving every manager into a style box, amount to jamming square pegs into round holes. Better solutions emerge when puzzle pieces fit together, and utilize mutually exclusive and exhaustive style indexes that explicitly include core. Only two style index families meet these criteria – Surz and Morningstar. Morningstar indexes are domestic only while Surz style indexes are both domestic and foreign.   

2Surz indexes are available on a number of platforms including Zephyr Style Advisor, MPI Stylist, Ibbotson Associates, Northfield, Factset, Pertrac, PSN/Informa, Frontier/SunGard, Open Finance Network, and Cainsoft


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