Style Consistency's Effect On Fund Returns

October 1, 2003

Two studies, two methodologies, two opposing points of view.

What is the secret to picking an excellent mutual fund? An endless stream of working papers, dissertations, and published studies have chased after the elusive answer. Most of these efforts, however, have ultimately proven disappointing. But the authors of two dueling studies, which tackled the question by exploring the consequences of fund style drift, hope to change this.

In the first study, Keith C. Brown, a finance professor at the University of Texas in Austin, and W.V. Harlow, a Fidelity executive, suggest that selecting style-consistent stock funds will often significantly boost an investor’s returns. Mutual funds that remained faithful to their stated investment style, the authors discovered, enjoyed better returns than those that disregarded their style mandate. Consequently, chances are greater that a large-cap growth fund that remains within its style box will perform better than a large-cap growth fund that wanders into, say, the mid-cap growth or large-cap value territory.

Do more style-consistent funds outperform less style-consistent funds? Brown asks. The answer is unambiguously yes. There is value in finding a more style-consistent manager.

Not so fast, says Russ Wermers, an associate professor of finance at the University of Maryland at College Park. His preliminary working paper suggests something different. The relation between style consistency and stock-picking talent is, at best, tenuous, Wermers says. Further, he found evidence that the best stock-picking managers often indulge in a significant amount of style wandering.

What makes this pair of papers notable is that academic literature has paid little attention to the consequences and causes of style drift. The researchers’ efforts, however, would obviously have been more welcomed if they shared the same bottom line. So what gives? The researchers suggest that one reason for this disconnect may be traced back to the distinct ways that style consistency was measured. Wermers used portfolio-based style analysis, while Brown and Harlow stuck with returns-based style analysis.

Each technique has enthusiastic supporters, which explains why debates on which method is superior have sometimes become emotional. Returns-based style analysis relies upon historical returns to provide an estimate of the average style position of a mutual fund or separate account during a given period. This type of software doesn’t look at actual portfolio positions. In contrast, portfolio-based software, which is what Morningstar Principia employs, analyzes the actual securities within a given portfolio to generate style information. You can learn more about both types of analysis by reading The Handbook of Equity Style Management, Third Edition, by T. Daniel Coggin and Frank J. Fabozzi (John Wiley, 2003). Coggin suggests that the heated bickering about which method is better has largely abated and that most experts now believe that both techniques deserve respect and often are best used together.

Curious about the contradictions in the two studies, Wermers is continuing his research in an attempt to determine whether the use of different style analysis techniques is the culprit behind the disparate results. He will also explore whether some of the performance advantage that style-inconsistent funds appeared to enjoy resulted from using net returns that don’t include fund costs. He expects to publish his findings later this year on his Web site at www.rhsmith.umd.edu/Finance/rwermers/. You can read Brown’s study at his Web site at www.mccombs.utexas.edu/

brownk/.

In the meantime, here’s some background on each study’s findings:

Brown and Harlow reached their conclusions after scrutinizing the performance stats of the 3,177 stock funds that were in Morningstar’s database from 1991 through 2000. The funds, which were grouped by style, fell into one of the nine main style categories: small-cap value, growth and blend; mid-cap value, growth and blend; and large-cap value, growth and blend.

The style-consistency premium was notable across the entire time period. Within certain categories, the performance gap was stunning. Stylistically pure small-cap growth and large-cap blend funds, for example, generated yearly median returns of 14.21% and 20.04% compared with 12.78% and 16.69% for their style-sloppy counterparts.

What you might find amazing is that the style-consistent funds enjoyed a performance advantage even after the researchers controlled for portfolio turnover and expenses. This is noteworthy because low fund expense ratios and modest portfolio turnover have been two of the only truly reliable indicators that could be used to predict superior performance in the future.

Arguably, the most famous fund study documenting that cheap is best was written by Mark Carhart, who is co-head of the Quantitative Strategies Group at Goldman Sachs Asset Management. In this landmark study, On Persistence in Mutual Funds, Carhart documented that there is a direct negative correlation between a fund’s returns and its expenses. In addition, Carhart concluded that another predictor of future performance is mediocrity. Dreadful funds tend to remain that way. In contrast, however, hot funds usually don’t burn bright for long. A fund that generated high returns during the previous 12 months often has one year of momentum left before it struggles.

Style-consistent funds are more likely to fit into the lower-cost category; obviously, with a style-pure fund, there’s not as much costly trading going on. The conclusion, then, that style consistency by itself could give a fund a competitive edge surprised John Rekenthaler, president of Morningstar Associates, a subsidiary of Morningstar. This is a surprising result, Rekenthaler says. When you look at a mutual fund and control for expenses and turnover rate, style consistency really shouldn’t matter.

Why should style consistency alone be such a big deal? Brown speculates that the managers who remain faithful to their little square in the style box are less likely to mess up their asset allocation and stock picks than those who try to time their style decisions.

This argument makes perfect sense to Arnie Wood, president and CEO of Martingale Asset Management in Boston. In more cases than not, he observes, when managers make changes in a portfolio and they leave their particular style, they tend to make more mistakes as they drift. And when they drift, they tend to fall into the same trap as individual investors: They run to whatever has done best recently.