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Evaluating Unconstrained Managers
August 31, 2010

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The following is in response to the article When Active Management Matters, by Ken Solow and Michael Kitces, which appeared on August 10. Solow and Kitces’ response is provided as well.

Dear Editor:

Solow and Kitces present some very good concepts in their attempt to rebuke Ibbotson, et. al.’s recent asset allocation studies; however, the authors wrongly place blame on style analysis instead of the process of applying the information provided by the style analysis.

I have problems with the following of their conclusions (the page and paragraph numbers refer to the PDF version of the article):

  1. Solow and Kitces state, “Unfortunately, a returns-based style analysis like Ibbotson’s may mask the benefits of active management when there are significant changes in exposure to various asset classes (Page 3, Paragraph 2)

    Style Analysis can be conducted with returns (RBSA) or holdings-based style analysis (HBSA).  Both approaches are designed to capture the style blend of an investment product. 

    While HBSA is highly accurate, it is often difficult to obtain a manager’s holdings in a timely manner. To overcome this problem, Nobel Laureate William Sharpe introduced RBSA, which uses the returns of a family of style indexes and the portfolio itself to determine a manager’s effective style mix.

    Although RBSA has gained tremendous popularity because of its ease-of-use, the user must understand the underlying sophisticated regression analysis being performed.  Like any statistical process, users may not recognize nor comprehend data flaws.

    When introducing his method in his 1988 paper, “Determining a Fund’s Effective Asset Mix,” (Investment Management Review, December, pp. 59-69) Sharpe clearly set forth requirements for the selected family of style indexes:

    • Mutually exclusive (no security can be assigned to more than one style)
    • Exhaustive (all securities are assigned to a style)

    Because Ibbotson used a mix of Russell Indexes, I question the accuracy of their style analysis.  Russell (as well as S&P and MSCI1) should not be used for RBSA because their indexes are neither mutually exclusive nor exhaustive.  This is the only real fault that I have with Ibbotson’s style analysis.  (If a stock does not demonstrate a strong value or growth bias, Russell and others place these stocks in both value and growth indexes.  This produces a statistical phenomenon known as mutli-collinearity and creates results radically different from the fund’s true effective mix.  Further, the results are questionable because none of these index families is exhaustive.)

    It appears that Solow & Kitces believe style analysis incorporates some sort of skill rating, which it does not.  Ibbotson’s use of RBSA may have problems, but claiming that it is able to mask or unmask benefits of active or passive management cannot be inferred.

1 Currently, only Morningstar and Surz Indexes meet Sharpe’s criteria for domestic equities and Surz is the only provider who meets the criteria on a Foreign and Global basis.

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