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Think Outside the Style Box

By Charles L. Norton, CFA
RealMoney.com Contributor
8/20/2004 8:30 AM EDT

Look through marketing material for almost any investment management firm and you're likely to see the organization define itself as either "growth" or "value." The delineation of investment styles has been a significant development over the years, and it has been particularly helpful in making asset allocation decisions. Style boxes have taken the notion of defined investment strategies even further, and these can be helpful in the asset allocation process. But this tool has its limitations, and investors who are not beholden to a particular style may improve their returns.

Get Inside the Box

Style boxes break down the U.S. stock market into nine investment styles, and they have become popular thanks in large part to Morningstar. They attempt to divide equity management strategies by the capitalization (large vs. small) and style (growth vs. value) characteristics of a portfolio.

These style boxes have become a very useful tool in the asset allocation process, because they enable an investor to make a specific allocation to a certain segment of the market through either manager selection or an exchange-traded fund.

The Style Box

This tool breaks the market down into a matrix of nine investment styles Source: Morningstar

Many institutional investors, such as pension plans, carefully choose investment managers to fill select boxes on this matrix. They may elect, let's say, large-cap growth managers, small-cap value managers, etc., and then monitor those managers to make sure their return profiles are consistent with benchmarks that represent each style.

For example, if a small-cap growth manager started to generate returns and risk characteristics vastly different from small-cap growth indices and more consistent with mid-cap growth, it would be deemed "style drift" and the manager could be fired. Whether his particular niche is in or out of favor, the manager's mandate is to fill the appropriate box on the grid. This means the manager usually has to stay almost fully invested, and should his style fall out of favor, he's going down with the ship.

The impetus is then on the institution to properly fill whatever boxes its staffers think will help meet their investment objectives. The idea is that by diversifying among managers, the institutional investor has some representation from most of the nine style boxes. Therefore, when one style is out of favor, they still will have exposure to another style that is performing better.

Style Boxes and the Individual Investor

Use of the style box isn't limited to the big institutions, however. There are a number of ETFs that can be used to fill all the different areas in the style box, and that allows smaller investors to perform a similar exercise.

For certain investors, this is a good way to go. While I agree that passive investors may want to use ETFs in their equity allocations, and in fact I have built a number of accounts using this approach, there's not a whole lot of alpha created in the process. You end up with a return that mimics stocks in general, and that could be a good (or bad) thing.

For some investors, that is precisely the goal. Asset allocation is the primary objective, not consistently positive equity returns. Other investors, however, just want to make money (or preserve capital) regardless of what the stock market is doing.

When the Box Becomes a Cage

As a money manager whose goal is to produce strong returns for clients independent of whether or not a particular style (or stocks in general) is in or out of favor, I find these style boxes very restrictive. If I know with certainty that there is not one box in that grid that will always remain in favor, why would I want to be limited to being fully invested in any one box? And if I know stocks don't always go up, why would I subscribe to a methodology that requires me to be nearly fully invested all the time?

What's in vogue in one market cycle will be unattractive in the next, and the value added by the investment manager is created by anticipating and participating in the style rotations.

A visual representation can make the logic behind this clearer. Callan Associates has published a table of the historical investment returns of different segments of the market from 1984 to 2003. This color-coded chart looks like a mixed-up Rubik's cube: There's no pattern whatsoever, which means that every year the performance ranking of different management styles and asset classes changes drastically.

For example, if you are a small-cap value manager (benchmarked to the Russell 2000, let's say), your style was the best-performing in 1988 -- but the second-worst in 1989 and 1990. If you are a large-cap growth manager who tracks the S&P 500 Growth index, your style was second-worst in 1992, dead last in 1993 -- and the best-performing management style for the next four years.

The Rotation Advantage

Managers who have the ability to rotate between styles depending on which sector is most in favor, and avoiding the areas that are performing the worst, can add a ton of value, or alpha, for their clients.

For example, if you had invested $1 in the S&P/Barra Value Index on Dec. 31, 1974, it would have been worth $15.93 on July 31 this year. That same dollar invested in the S&P/Barra Growth Index over the same time period would have grown to $15.44. However, hypothetically, if you had perfect information and had been able to switch back and forth between the two indices depending on which one had a better monthly return, your buck would have increased to $418.28 in the same period.

That's not possible in the real world, of course, but it illustrates that because at some times growth outperforms value and at other times value beats growth, you're better able to profit from these rotations if you're not limited to one or the other.

Style boxes have been an important development in asset allocation, and for passive investors they make a lot of sense. But being stuck in a box limits your ability to profit in all market cycles and pretty much ensures periods of underperformance. While they serve a purpose for some, style boxes can be an impediment for versatile managers. Don't put me in one.