In Part I of my series on active investment management, I described two types of research that attempted to help advisors uncover above-average talent: identifying conditions where you are more likely to find outperformers, anBob Veresd betterways to identify above-average managers.

As it turns out, there’s a third possibility. Instead of identifying superior funds, you identify superior combinations of funds – which, of course, includes a fund selection process, but then takes it one step further.

To see how this works, meet one of the most interesting researchers in the asset management space: Gary Miller of Frontier Asset Management in the global financial capital of Sheridan, WY. Frontier manages $1.8 billion in assets, either directly via separate accounts with advisory firm clients or through the Envestnet platform.

Miller’s investment philosophy contradicts everything you hear from traditional academic research. “We come to this with three core beliefs,” says Miller: “active fund managers can add value; we can identify those managers in advance, and they will continue being successful.”

Beyond style boxes

Miller’s process for identifying fund managers who add value requires several steps. First, he surveys the fund universe using returns-based style analysis (RBSA), a tool that he co-invented with Nobel Laureate Bill Sharpe. RBSA compares each fund manager’s monthly (or, at times, daily or weekly) return performance against all the possible mixes of index returns. The goal is to use a complex regression analysis to determine, with some precision, which asset classes each fund is invested in, today and historically.

Step two is to compare each fund’s returns against its own customized benchmark, so Miller can see whether or not the manager is adding value.

What’s wrong with simply measuring a fund’s returns against the average performance of its style box? “Style box investing just doesn’t work,” Miller says, “because it allows one set of managers to outperform during different periods simply because of the way they invest.”

As an extreme example, consider the most successful funds in the frenzied bull market leading up to the tech bubble burst. “In each style box category,” Miller says, “the top of the peer group were the funds with the largest cap weightings that were also the most growth-oriented.” In other words, they had the advantage of being more exposed than their peers to the larger-cap growth stocks that were being bid up in the frenzy.

When the bubble burst, those same managers dropped like stones to the bottom of their style box rankings, because their over-weightings were now dragging them down instead of lifting them up. This is an exaggerated example of what happens all the time: when growth outperforms value, the value funds with the highest growth orientation will outperform their deep-value peers. Unless you have a much finer calibration tool than nine style boxes, it’s impossible to know whether a manager is adding value compared to the actual investment category he/she is invested in, or whether the outperformance is due to the random winds of the marketplace.

Interestingly, the more precise style analysis rankings tend to eliminate low-active-share managers – which relates to the active-share research referenced in my first article in this series.

After reading through the literature, however, Miller decided not to use active-share screens because he says it’s just as likely to identify funds with high negative alpha as above-average ones. But he says that there’s a qualitative explanation for why high active-share managers tend to rise to the top of the style analysis rankings, closely related to the comments by Morningstar’s Don Phillips that I cited in Part I of this series. Some fund companies are more focused on their own growth and profits, while others are more concerned about delivering above-average performance to their investors, potentially at the expense of their own organization’s growth and profits.