Strategy Based Framework Improves on Style Grid

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A simple question was asked 30 years ago: “How should we group and evaluate active equity fund managers?” The answer to that question is the widely accepted style grid of market capitalization and value-growth. It was arbitrary, lacking research or academic foundation. Regardless, the widespread adoption of the style box has had pernicious, unintended consequences as managers are incented to adhere to it and track arbitrary benchmarks.

A powerful alternative is to organize managers by the investment strategy that a fund pursues. Once constructed, these statistically valid peer groups provide a comprehensive framework for portfolio construction, manager evaluation, fund selection, and benchmarking, and, quite surprisingly, can be used for stock selection and for managing market exposure or, in short, strategy-based investing (SBI).

Investment strategy as a new framework

Investment strategy – or process, or methodology – is the actual way a manager goes about analyzing, buying and selling investments. Strategy encompasses the manager’s general approach to stock picking as well as the specific elements upon which the manager focuses. This concept also applies to other asset classes.

As an example, a valuation manager (one of the 10 equity strategies to be introduced shortly) identifies and invests in undervalued stocks. The elements used by the manager to implement the valuation strategy might include P/E ratios, valuing future cash flows, or being a contrarian. Drilling down further, the specific criteria used by the manager, such as purchasing stocks with a P/E of less than 15, are the manager’s “secret sauce” and are not part of strategy categorization.

Armed with this basic, yet essential understanding of how professionals manage portfolios, organization around investment strategy is a powerful approach to investment management. Anyone who has looked at a large universe of managers quickly realizes there is a broad spectrum of investment strategies and a wide range of specific investment elements.