0:03
In the previous module, we looked at several risk adjusted return measures
that can be used to evaluate performance.
The problem, however,
is that most of these return performance measures can be gamed.
For example, suppose a fund manager claims to provide index exposure only.
What if he buys futures on the index and invests the remaining of the assets on
a momentum strategy that has zero correlation with the index, right?
What we really want to do in order to better evaluate performance is dig in
a little deeper to determine how much of the portfolio return is due to the style
0:46
and how much is really due to selection, right.
The return due to selection basically is a difference between the fund return and
that of a passive mix of similar styles, right.
Now this is an important distinction, right, because it is only the return
due to selection of course, right, that can be attributed or
contributed to a talent or the skill of fund manager, right.
1:27
All right, so what is style analysis?
Well, broadly speaking, style analysis is a powerful and
sophisticated technique, that was also developed by William Sharpe,
to analyze the investment styles of portfolio managers, right.
The key element of this technique is the ability to describe the performance of
a fund, not by looking at the individual portfolio holdings, not by looking
at what the portfolio holds, but rather by looking at how the portfolio's
historical returns are related to various investment styles, right.
In other words, by looking at how the portfolio returns act, so
to speak, rather than what the portfolio holds, right.
But what is an investment style?
Well, an investment style can be thought of as a method of investing or
even as a kind of benchmark, right.
2:24
So for example, while in the US, right,
the industry terminology for equity styles varies somewhat.
The style definitions have somewhat converged to the point that they typically
include some classification of both the capitalization orientation and
the location on the value and growth continuum, right.
So this table, for example, shows how these different equity styles relate
to the different segments of the equity market, right.
So you can think of the market being broken into a three-by-three matrix,
right, based on market capitalization, large-cap, mid-cap,
small-cap and investment style, right, value, market-oriented, growth, right.
So for example, a portfolio manager who primarily invests in
small-cap stocks would be said to follow a small-cap growth style, right.
Now there are other investment styles as well, right?
Other investment styles could be large-cap value style or
even a government bond style, right.
And finally, a portfolio could itself represent a mix of different styles.
3:40
For example, this graph from Sharpe's original paper on the topic, right,
a style analysis that analyzed fund styles illustrates how the famous
Fidelity Magellan fund was once classified largely as a combination
of growth stocks, right,
medium cap and small cap styles, with a little bit of
4:07
Foreign stocks during the 1980s, right.
So this graph on the left here illustrates
the contribution of the different styles to the fund returns, right.
Now the pie chart on the right, right, shows that during this period,
right, over 97% of the monthly variation in the Magellan returns could
be attributed to the return on a passive portfolio with similar styles, right.
The remaining, of course, is the component of return due to selection, right.
Now here's another graph for you from the same paper, right.
4:47
This graph shows you how the investment styles of the Magellan fund shifted
over these periods, right, progressively increasing its exposure to large
growth stocks and decreasing its exposure to small-cap stocks during the 80s, right.
Now this is not surprising, because as the fund grew, right,
it became increasingly difficult to invest in small stocks.
So the style analysis, as a tool, right, can be used in many different ways.
It's informative in many different ways.
For example, right, as I showed, often funds may have a stated objective,
but a style analysis can be used to determine whether a fund
strategy does actually follow this stated objective or
whether it has deviated from the stated objective.
Two, right, it can be used, right, the style analysis gives you a tool
to create a true benchmark for the portfolio in question, right,
rather than some arbitrary benchmark like the S&P 500, right.
Put differently, it helps us to evaluate what part of the portfolio
return can truly be attributed to selection rather than style, right.
As I said before, right, this is the part, the selection,
right, this is the part of the fund return, right,
that the manager should get compensation for, right.
After all, we can very easily create the same style mix by holding simple right,
passive indices for the same styles, right.
And finally, it provides a more accurate picture of the exposures of a fund,
right, that you may be investing in, and therefore, it is informative
in evaluating how this fund best fits with your overall portfolio.
Arzu OzoguzFinance Faculty
