Sharpe sets the tone, but style analysis is changing

This essay appeared in Citywire Selector on October 13, 2009.

In the recent history of the asset management industry, few topics have been as strongly contested as style analysis. The uses and misuses of the concept and tools associated with it continue to have serious implications for how managers are rated and selected.

Fund selectors are at the very heart of this broad-reaching and complicated topic. In Europe, the influence of style analysis has been more muted than in the US, where the concept was first developed, and in some cases taken to an extreme.

As the use of style analysis becomes more prevalent in Europe, fund selectors have an opportunity to determine the future direction of the industry and learn from some of their US colleagues’ mis-steps.

Though the genesis of the concept was arguably formed earlier, the seminal academic work on the subject is William Sharpe’s paper Asset Allocation: Management Style and Performance Measurement, published in 1992.

In it, Sharpe develops the basic principles of the theory. He systematically lays out a methodology for determining the asset class factors that contribute to the performance of a fund. The approach he developed is known as returns-based style analysis, as it uses only the historical returns of a fund in relation to the returns of several indices used to define the asset classes.

He provides several detailed examples of its application. To understand Sharpe’s motivation for his efforts, the subtitle of the paper is illuminating: ‘An asset class factor model can help make order of chaos’. Sharpe viewed the rapidly growing fund industry as being in need of classification and structure. If investing is part art, part science, William Sharpe’s approach is all science, all the time.

Since the 1980s, he has worked extensively in shaping the field of asset allocation. He is not an advocate of active asset management. He worked with Wells Fargo in the creation of the first index mutual funds in the 1970s and he was early to capitalise on the theory that asset allocation, not stock selection, is the primary driver of returns.

From his perspective, the key function of the asset manager is to maintain the proper exposure to the asset class for which he or she has been hired. Ultimately, the most efficient and effective way to implement the asset allocation model in its purest form is by means of vehicles that provide direct exposure to the indices representing the asset class. In other words, passive indexing.

In 1990, Sharpe received the Nobel Prize for economics for his contribution to the capital asset pricing model. He had the ultimate medal of credibility and was intent on using it to progress his interests. His 1992 paper was readily adopted by investors – and set in motion a trend that continues to colour developments.

1992 was a key year in another respect for style analysis – it marked the introduction of the Morningstar style box. Morningstar uses a different methodology from Sharpe’s but with similar goals: to provide investors with insights into the style of a fund without needing to rely on the manager to provide the analysis. Morningstar’s approach analyses a fund’s holdings in terms of its market capitalisation and a range of financial factors, which determine its position within the style box. The Morningstar style box continues to be a hallmark of the company and a deceptively easy visual guide to depicting a fund’s style.

The insights to be gained through style analysis are without doubt important. The question for fund selectors is not whether or not to perform style analysis – with the growth of the new generation of funds, and the need for more transparency, selectors should use every tool available.

On the other hand, selectors need to ensure they do not overestimate the capabilities of the tool or become blindly reliant on it.