Making Active Equities More Stylish
Smart Thinking: A Skill Versus Luck Essay Series | Issue 2
Written by Michael A. Ervolini
Making Action Equities More Stylish
INTRODUCTION
Style analysis is used regularly to support equity fund assessment and allocation decisions. While this analytic offers useful insights, its value in determining a fund’s desirability may be more limited than generally perceived. It can deliver unintended consequences that diminish rather than enhance ultimate outcomes. This essay clarifies the benefits available from style analysis and offers an improved approach for its use in supporting active equity fund assessment.
GOT STYLE?
In his landmark 1988 paper “Determining a fund’s effective asset mix”, William F. Sharpe described a method for assessing the style characteristics of an equity fund.*1 Since then style analysis has become an integral element of fund assessment, allocation decisions, and confirmation that a fund is acting in accordance with its strategy and purpose (i.e., identifying style drift).*2
The debate continues regarding whether Sharpe’s return-based analysis or the alternate holdings-based method yield the more creditable result.*3 The returns-based approach resolves which asset indices best explain (i.e., are most correlated) with the return series of a fund or portfolio. Return-based style analysis is commonly referred to as a top-down approach. Holdings-based analysis takes a more bottom-up path by first determining the style or factor characteristics of each of a fund’s holdings over time. For example, some holdings may be more growth oriented while others more value oriented. Factor levels are then aggregated across holdings to formulate the fund’s overall style.
WHAT YOU GET
Both approaches have their strengths and shortcomings. But each serves a basic role in fund assessment. In the words of Sharpe: “All that style is is exposure. If I say your style is 60% growth and 40% value that means you'll move 0.6 times whatever happens to growth stocks plus 0.4 times whatever happens to value stocks.”*4
The algebra cited by Sharpe holds to the extent that the fund continues to be managed in the future much the way it was managed in the past. Meaning that the fund owns an array of stocks such that the returns going forward, or the factor composition of its holdings are based on similar bets as were previously taken (i.e., exposures to large/small caps, growth/value, interest rates).
A diversified fund that is highly consistent in the stocks it owns fits this bill. So does a diversified fund that rotates from one factor to another regularly. Style analysis can be less helpful for a highly concentrated fund. Here a couple of positions can dominate the fund’s factor exposures. And the dominant positions can change in response to market forces rather than manager intention. This can result in substantial style shifts that may be of limited value in estimating future exposures. A similar diminution in usefulness of style analysis is encountered for a fund that has recently and permanently changed its strategy or alpha sourcing. Although it is important to be mindful of these two latter considerations the bigger issue is the frequent misapplication of style analysis and the unintended consequences therefrom.
THE STYLE TRAP
What can style analysis say about effective fund management? In good part it depends on the question being investigated. One common use of style analysis is the assessment of style drift. Drift is indicated by a set of current factor exposures that differ meaningfully from the fund’s historic exposures (i.e., the style changed). Typically, the desired outcome is the absence of style drift or, stated in the affirmative, consistent factor exposures. However, exposure consistency frequently comes at a high cost.
Consider a value fund. It is fully expected that this fund is purchasing mostly (if not exclusively) stocks with a clear value signature. Which means that at time of initial purchase these stocks fit the value style. But what about new buys that then go on to generate significant excess returns? As these positions experience improving fundamentals and upward price movement, they begin to shed their value characteristics and edge into growth territory. One assumes that this evolution is a primary reason for buying value stocks in the first place. The intention being that enough of these value stocks will outperform sufficiently so that the fund itself can generate excess returns.
All too often, however, value funds significantly trim or liquidate their strongest performing positions prematurely. These actions are taken well before such successful buys have exhausted their ability to generate excess returns. It’s done to ensure that the fund is not perceived as drifting outside of its value style box. Managers that engage in such activities believe it is what clients want. They are often told that: “The client is allocated to the fund based, in good part, on its style or factor exposures. Departures from historical style are likely to complicate (or even compromise) the client’s overall risk management.” In Such situations adherence to style or overall factor exposures supersedes the capture of excess returns. Clearly, managing risk indirectly through style allocations brings with it unintended consequences.
GOING STYLISH
There is an alternate and for many better ways of confronting the question of style. It involves selecting funds based on the types of stocks they purchase rather than all the stocks they own.*5 Within this formulation value funds are expected to purchase value stocks, growth funds are expected to purchase growth stocks, and so forth. Once a position is established, however, the fund is then expected to maximize its contribution to excess returns subject to prespecified levels of risk control. This enables value fund to own growthy stocks that were initially purchase when they were clearly value. It allows a small cap fund to own mid cap stocks that have performed well and grown out of their small cap designation. It improves the potential for funds to realize excess returns while purchasing stocks that fit a specific style designation.
Allocating to funds that operate as described requires some rethinking and retooling on the part of asset owners/allocators. In particular they need to take a greater role in managing the overall risk exposures across their equity platforms. By analyzing the complete set of all their equity positions (internally and externally managed) they are able to offset over and under exposures more comprehensively. And in doing so they give a greater degree of freedom to each manager that can be used in the pursuit of excess returns.
CONCLUSION
Actively managed equities continue to be an important asset class for many investors. Institutional asset owners/allocators can increase the value available from this asset class today by focusing style analysis directly on the types of stocks being purchased rather than on conformity of fund overall exposures. This will allow funds to hold on to their strongest positions longer and capture even greater excess returns. Replacing traditional style conformity and using a “purchase what is expected” approach is already helping a growing number of asset owners/allocators improve the results from their equity programs. These investors are capturing greater excess returns while making equity investing ever more stylish.
ENDNOTES
- William F. Sharpe, “Determining a fund’s effective asset mix,” Investment management review, 1988.
- “RETURNS - VS. HOLDINGS - BASED STYLE ANALYSIS”, Beacon Pointe Research White Paper, Beacon Pointe Advisors, LLC, September 2022.
- Paul D. Kaplan, “Holdings-Based And Returns-Based Style Models”, MorningStar, Inc. June 2023.
- Barry Vinocur, “Setting The Record Straight On Style Analysis”, A Newsmaker Interview, Stanford University, 1999, http://www-sharpe.stanford.edu/fa.
- Michael A. Ervolini, “Skill Versus Luck – Taking The Guesswork Out of Equity Fund Selection”, MIT Press, February 2026 (forthcoming).
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