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Rekenthaler Report

From the Archives: The Style Police Were Right

Those stock funds that moved less, profited more.

This column was originally published on April Fools' Day, 2016. But it was written in earnest.

Speed Traps?
The 1990s were the decade of the "style police." Armed with the new tool of Morningstar Style Boxes, investment professionals surveilled equity funds to guard against "style drift." Funds that moved from grid to grid were liable to be swapped out of client portfolios, replaced by steadier rivals. Literally and metaphorically, Rudy G. presided over Wall Street. Law and order was in order.

I exaggerate not. Putnam staked its brand on convincing financial advisors that its funds were the industry's most style-pure. Most investment consultants screened funds for style movement, using only those funds that passed the test. Subscribers urged Morningstar to publish style ratings, with the obedient funds branded as "style consistent" and the movers as "style drifters."

The style ratings did not happen, because Morningstar did not wish to encourage the trend. (Some of the company's software programs added a calculation that showed a fund's level of style flexibility, but that feature was neutrally worded and downplayed, and it did not appear on Morningstar's standard fund reports.) The style box had been created to describe, not prescribe. Morningstar's research group was not at all certain that style policing would lead to better investment results.

In fact, Morningstar tended to believe the reverse case. The industry's most successful stock-fund manager, Peter Lynch, invested in a variety of stock types. Its most successful corporate manager, Warren Buffett, did likewise with his insurance company's portfolio. Many other top fund managers (Bill Miller, Ken Heebner, the Sequoia crew) had portfolios that tended to wander. Yes, eliminating style-drifting managers eased a consultant's task; funds could be plugged into a box and then forgotten. But at what investment cost?

In writing that, I reconvinced myself of the argument's wisdom. Those who make investment recommendations should not eliminate potential outstanding purchases solely because of operational concerns. Indeed, among the services that investment professionals allegedly offer are gathering better information and implementing more-complex strategies. There was no investment merit behind the desire to police style.

The Evidence
Except … there apparently was.

Investment Style Volatility and Mutual Fund Performance, a 2015 paper by two professors and an industry executive (at … yes … Putnam!), demonstrates that style-consistent funds have, indeed, been superior. The authors write: "On average, funds with lower levels of style volatility significantly outperform more-style-volatile funds on a risk-adjusted basis. We conclude that deciding to maintain a less volatile investment style is an important aspect of the portfolio management process."

This column found much the same when examining the issue of whether flexibly managed U.S. stock funds (that is, those funds that were not style consistent) beat those that followed a straighter path. My inquiry was different than that of Investment Style, however, in that it did not attempt to show any path's superiority. Instead, it merely defended the null argument, that claims for flexible funds appeared to unsupported by the numbers. In contrast, the Investment Style paper wishes to name a victor.

Also, the authors measure style movement differently. Morningstar defines investment style as consisting 50% of company size (stock market capitalization) and 50% of where it falls on the value/growth spectrum, with price/book being only a small part of that calculation. The Investment Style authors, on the other hand, opt for the three figures of company size, price/book ratios, and stock-price momentum. Their approach is loosely related to Morningstar's, but only loosely.

As befits an academic paper that has been vetted by dozens of outside readers, Investment Style uses a much longer time horizon. My column examined the results over the trailing 10 years. In contrast, the Investment Style authors examine the 32-year time period from 1978-2009. As it turns out, only 12% of their study's time period overlaps with that of the column.

Moreover, while my study evaluated the results over a single horizon (thereby raising the issue of survivorship bias), the authors used rolling one-month, three-month, six-month, and 12-month periods. Effectively, my column wondered: If an investor bought and held a U.S. stock fund over a single decade-long time period, would that investor have been better off with a flexible fund? In contrast, Investment Style asks: Over the next few months, how should we expect the pool of style-consistent funds to fare against the pool of inconsistent/flexible funds?

Finally, Investment Style uses other companies' data. (Boo!) The funds' total returns come from the University of Chicago's Center for Research in Security Prices, and the portfolio-holdings information from CDA/Spectrum. So there is no possibility that some feature in the design of Morningstar's data has affected the authors' results.

For all practical purposes, then, Investment Style and my column were independent inquiries.

Their outcomes, however, were the same. Just as this column's investigation found that the average flexibly run fund trailed those funds that were style consistent, so does Investment Style. Of course, the usual caveat about averages applies. "Although our results do not negate the possibility that managers who follow an explicit tactical style-timing strategy can be successful, they do suggest that indirect style volatility can lead to inferior relative performance." Yes, there may well be flexible managers who defy the odds. No, that is not the way that an investor will normally wish to bet.

The authors conclude, "The decision to maintain a stable and predictable style profile may be more useful in helping managers avoid chronically poor performance than in creating an environment that fosters persistent superior relative returns."

In other words, as Morningstar's Don Phillips likes to state, one key to investment success is avoiding avoidable mistakes. Style-consistent stock funds might not accomplish brilliancies, but they don't generate the trading costs--and, often, charge such high management fees--that are paid by their less-consistent rivals, and they also do not get whipsawed by chasing hot sectors. Sometimes, less is indeed more.

A Happy Accident
The style police of the '90s did not have evidence supporting their contention. The numbers had not been run. They had a thesis that sounded good and could be used to sell a certain segment of funds--just as the flexible-fund advocates who were on the other side of the argument could also tell a fine story and also had funds that they wished to distribute. The odds were high that neither of them would be correct, so that the overall contest between the two approaches would be a wash. Most battles between investment "philosophies" end up that way.

But this bout appears to be the exception. It seems that the style police were right. Only so by accident, I believe--but nonetheless, credit should be given when credit is due.

John Rekenthaler has been researching the fund industry since 1988. He is now a columnist for and a member of Morningstar's investment research department. John is quick to point out that while Morningstar typically agrees with the views of the Rekenthaler Report, his views are his own.