Thinking Out of the Style Box

As portfolio construction has become increasingly complex, many investors (and advisors) have turned to a simple and convenient tool to bring structure and discipline to their portfolios — the style box.  Style boxes have become so widely used that the familiar grid has become the standard representation of asset allocation and diversification.  While it’s hard to question the utility of boxes, there is growing evidence that the interests of investors might not be best served by rigid adherence to the common application; style-box investing.

What is style-box investing anyway?  It began with Morningstar, which is based in Chicago and is a widely respected research firm.  The company developed a comprehensive strategy for categorizing stocks called the Morningstar Style Box.  The nine-box grid divides stocks into three distinct size factors (large, medium and small) and three valuation factors (value, core and growth).  Even the popular financial media have adopted the language of the nine-box grid such as growth or value…and detailing mutual funds as “large cap value” or “small cap growth”.

                                                  Alcatraz Prison, San Francisco, California

                                                  Alcatraz Prison, San Francisco, California

Several academic studies have concluded that “boxing in” a portfolio can increase volatility and reduce returns.  In fact, Morningstar, which introduced its nine-box grid in 1992, has said that the boxes were never intended to construct a portfolio. The system imposed by boxes seems rational, but it lacks flexibility which is contrary to the ultimate objective of investing. Flexibility is required both to pursue compelling opportunities and to minimize risk.  Money management requires rigorous analysis, the ability to invest with broad mandates and vision that extends beyond artificial boxes.  The bottom line:

  • Style boxes are now widely used to construct and monitor portfolios.
  • Boxes were designed to evaluate and monitor investments not to be a rigid framework for asset allocation.
  • Research indicates that managers constrained by style boxes underperformed "unconstrained" managers.
  • Stock selection should be based on a company’s ability to deliver long-term value to shareholders, not on staying in a style box.
  • Managers that focus on strategy-based investing rather than an arbitrary "style-box" have greater flexibility and may provide higher returns with lower volatility.

Many advisers have adopted the style box in an effort to bring discipline and structure to their portfolios.  The style box has (unfortunately, as you will learn) become the most widely used tool for making investment decisions, representing an easy and well-defined solution to the common challenge of asset allocation and diversification*.  However, this trend has taken some investments far from their original purpose of competent investment management selected through rigorous research and analysis.  The emphasis on the self-imposed "boxes" has made some fund managers reluctant to purchase stocks that reside outside of the fund’s style box.  Because when they do, the fund is perceived as engaging in “style drift”.  This deviation is perceived as negative and often results in it being unfairly punished ("sold") by advisers and institutional shareholders.

How and when did this situation develop?  The trend can be traced to the 1980s and the genesis of style indexes.  Introduced as a method to help characterize the investment styles of managers, the boxes provided a simple tool to evaluate managers. They also provided financial advisers with a framework for making decisions on behalf of their clients.  Yet it has now evolved into perverse criteria for manager selection and asset management.  The adoption of style boxes has become so widespread that they’ve fundamentally altered not only asset allocation, but arguably portfolio management.  As the boxes gained acceptance, investors began to seek out managers that adhered to a predetermined investing style, such as large-cap growth or small-cap value.  In response, the investment industry began to cater to the market by creating "product" designed for specific categories.

Several factors then converged to make style boxes the dominant method of asset allocation.  Some consultants, planners and advisers have come to depend on boxes, partly due to the relative ease in assembling, rebalancing and explaining portfolios built in the style-box framework.  Many believe style boxes represent a prudent way to diversify portfolios and that placing limits on a given style provides discipline for investors.  In fact, the system has become so pervasive that there is often limited tolerance for managers that don’t fit neatly into boxes.  Managers that do not adhere to a style box can be labeled with style drift and become candidates for replacement by ones that seem true to that box’s profile.

Doesn't this all sound neat and tidy?  It certainly makes money management appear easier for investors and more convenient for brokers, advisors and planners to "sell" product.  So what is wrong with it?  Simple -- it doesn't work and it impairs performance! There is a growing body of evidence that adherence to style-box investing can increase volatility and reduce returns.

In the 2005 study, “The Problematic ‘Style’ Grid” by Craig Callahan, president of ICON Advisers, and Charles Howard of the University of Denver found that style boxes can lead to underperformance by placing artificial constraints on portfolio managers.  “In order to produce superior returns, managers must be allowed to pursue their unique style and have access to the entire stock universe, which means that the resulting portfolio experiences characteristic drift,” Callahan and Howard wrote.  Their study concluded that portfolios of unrestricted managers outperformed the style-box driven managers by 3.39% per year from 1995 to 2003.

Other studies, using data from 1984 to 2003, have made the same point — returns can be diminished when managers are confined to boxes defined by market capitalization and value-growth characteristics.  The “studies approach the question from different directions, but basically come to the same conclusion: staying in a box or hugging an index is detrimental to…performance,” Callahan and Howard wrote in “Strategy Based Investing: Out of the Box,” published in Strategic Insight’s Windows Into the investment management industry, August 2007.

Russ Wermers at the University of Maryland reached a similar conclusion in his 2002 working paper “A Matter of Style: The Causes and Consequences of Style Drift in Institutional Portfolios”.  He wrote, “Managers holding portfolios with greater levels of style drift --provide substantially higher levels of performance, on average, than their counterparts.”  In a subsequent report, “Measuring and Managing Style Drift in U.S. Institutional Equity Portfolios,” Wermers’ findings show that from 1985 to 2000 “high style drift managers outperformed low style drift managers by as much as 300 basis points a year.”

These studies make several points about investing by the box.  Rigid adherence to "boxes" will force managers to work toward objectives that diverge from those of the investors.  Further, efforts to fit into a box (and stay there) place constraints on investment managers that can lead to poor results.  (Several of these studies also indicate that diversifying among boxes does not necessarily ensure risk reduction, the often cited benefit.)  Finally, Morningstar has made it clear that they never intended for boxes to constrain investment managers or drive portfolio construction.

We believe in two core principles; the investment process should be driven by client goals and portfolios should be constructed from the bottom-up, selecting managers that adhere to a process that can be defined and repeated.  In other words, evaluate managers based on their decision-making process and the results.


For more information on INVESTMENT MANAGEMENT, read these related articles:

Risk Tolerance & Performance

6 Traits of Successful Investors