By Jason Zweig | Jan. 1, 2018 1:35 p.m. ET
Image credit: Pieter Bruegel the Elder, “Two Chained Monkeys” (1562), Gemaldegalerie, Berlin, via Google Art Project
Here, from my archives, is a piece I wrote about how portfolio managers were being shackled by “the style police,” investment consultants and financial planners who demanded that they invest with rigid adherence to predetermined allocations. Of course, you could buy that sort of mechanical obedience with an index fund at a fraction of the price, so “style purity” made no sense to me. Why pay a human not to use his or her judgment when you could have a machine invest mindlessly for next to nothing? If you want to use an active manager, you must encourage him or her to be more active, not less. That doesn’t mean trading more often; it means thinking more independently.
The Tyranny of Style
Money Magazine, December 1999
Is a mutual fund’s label more important than its returns?
There’s an old saying that every bad idea starts out as a good one. Karl Marx wanted to stop the oppression of factory workers, and he ended up creating Communism. Somebody in Japan wanted to give kids a new way to have fun, and that led to Pokemon. Financial planners realized that some portfolio managers buy stocks that don’t seem to belong together in the same fund, and we got “style purity.”
No wonder market-beating fund managers are almost as rare as Pentecostal preachers in a Jesse Ventura fan club. These days, the trendiest way to measure a fund’s performance has nothing to do with whether it beats the market or even whether it makes money. Instead, say influential financial planners and pension consultants, a good mutual fund practices style purity — meaning that it always invests your money in exactly the same way.
That sounds like a good idea. Once you’ve decided you want 10% of your money in a fund that holds cheap little U.S. stocks, you’d be pretty annoyed if your small-cap value fund bought 23 overpriced underwear manufacturers in Indonesia. Similarly, a large-cap growth fund is supposed to buy only large companies with rising earnings. And a mid-cap blend fund belongs firmly on the fence, never tilting toward big or little stocks — nor toward truly cheap companies or very fast-growing ones.
The ultimate tool to assess funds this way is the style box. The researchers at Morningstar Inc. sort funds into three rows and three columns, like a tic-tac-toe grid. The rows denote the average size of a fund’s stocks: large, medium and small. The columns sort a fund’s holdings by average price: cheap value stocks, more expensive growth stocks, or a mix of the two, blend stocks. So every stock fund falls into one of nine pigeonholes: small-cap value, blend or growth; mid-cap value, blend or growth; and large-cap value, blend or growth.
But what happens if a mid-cap value manager buys a stake in a giant stock like Philip Morris because it seems irresistibly cheap? That can drive up the average size of his stocks from medium to large — and move the fund into another box. In the legitimate pursuit of a bargain, the manager has committed what planners and consultants call style drift. To them, that’s an unforgivable sin, because they’ve designed their clients’ portfolios to have predetermined amounts of money in each pigeonhole.
“When a fund goes through style drift, it creates an imbalance and throws off our asset allocations,” explains Carol C. Pankros of CCP Inc., a financial planning firm in Palatine, Ill. that has more than $50 million invested in mutual funds for its clients. “We own [a small-cap fund], and lately it’s been drifting toward midcap, and we’re sitting here going, ‘Huh?!’ And now we may have to sell it.”
It’s no wonder one fund company, Lord Abbett, recently ran an ad in a brokers’ magazine featuring the international symbol for a big no-no — you know, the red slash in a red circle — stamped over the words STYLE DRIFT. For that matter, I’ve criticized style drift in some of my columns too.
But it’s time investors asked some simple, commonsense questions.
If you own a value fund, do you really want its cheap stocks to stay cheap? And isn’t the whole point of buying small stocks the hope that they will eventually get big?
Listen to Ralph Wanger, who runs the Acorn Fund (“small-cap growth”): “Buying stocks that go up — that’s not the worst thing that could happen to you. In fact, it’s the best thing. And a small-cap fund that stays small-cap forever — that’s like being a thin chef: Maybe something’s sort of wrong.”
Or take Bill Miller of Legg Mason Value (“large-cap value”), who bought America Online and Dell in 1996 at, respectively, $5.22 and $1.19 a share (adjusted for splits). Now that both of those stocks have gone on to multi-thousand-percent gains, has Miller betrayed his “value” roots — or has he simply been proved right?
You want your fund manager to pick the best stocks, not the best stocks that fit in a box. But, notes John Rogers, who runs the $215 million Ariel Fund (“mid-cap blend”): “Portfolio managers are spending a disproportionate amount of time thinking about which style box they’re supposed to be in rather than doing fundamental research on stocks.”
That can lead to downright daffy results. Acorn’s Wanger explains, “This year we sold [a portion of our stake in] Carnival Cruise Lines, Harley-Davidson and Liberty Media to make sure we could still meet the Morningstar criteria [for a small-cap fund].” I asked Wanger if he still thought they were good stocks. “We might have liked to hold onto them for, oh, another 20 years or so,” he said dryly. “We sold them because of marketing considerations, not investment considerations alone.”
Thanks to those marketing considerations, Acorn’s shareholders (and those at hundreds of other funds facing the same pressures) will now be saddled with a capital-gains tax bill they would not otherwise have had to pay.
What does Morningstar’s president, Don Phillips, make of this? “It worries the heck out of me,” he says, “when a fund manager comes up to me and says, ‘I’m selling some of my best stocks so I can stay in the same style box.’ We intended our style boxes to be descriptive: what a fund does own. We’ve never marketed them as being restrictive: what a fund ought to own. Too many people are using them that way.”
The King of Style Drift
How can a fund manager pick good stocks for you if his or her hands are tied? To see that style drift isn’t always bad, look at Peter Lynch. From 1977 through 1990, the great manager of Fidelity Magellan bought whatever his research led him to believe would go up — not just big growth stocks, not just U.S. stocks, sometimes not even stocks. In 1982, his biggest position was in U.S. Treasury bonds — and he later threw in a heap of Australian bonds for good measure. In 1986, he had nearly 20% of the fund in foreign stocks like Honda, Norsk Hydro and Volvo.
In short, Lynch was the king of style drift — but you never heard any of his shareholders bellyaching about it. Why would they? After beating the market by more than 13 percentage points annually, Lynch could drift all the way to Tierra del Fuego and his investors would still be delighted to go along for the ride.
I’m afraid the obsession with style purity is in danger of dooming nearly all mutual funds to mediocrity. If Lynch tried to run Magellan today the way he did 15 years ago, he’d get whacked right back into the large-cap blend box. Think I’m exaggerating? That’s exactly what happened to one of Lynch’s successors, Jeffrey Vinik, in 1996, after Vinik put a hunk of Magellan’s assets into Treasury bonds — just as Lynch had done (more profitably) a dozen years earlier. The style police whipped out their nightsticks and within six months Vinik left Fidelity to start a private hedge fund — which has been wildly successful for the multimillionaires who can afford to invest in it.
Fortunately, Lipper Inc., another leading fund-research firm, has just come out with a way of classifying funds that is a helpful supplement to Morningstar’s tic-tac-toe grid. Lipper has kept the divisions for small, medium and large stocks, as well as the distinctions between value, growth and blend (which Lipper calls core). But Lipper has added a new group it calls multi-cap. These are funds whose managers are not in stylistic shackles; they invest in whatever they think will go up. Lipper’s new groups have their own flaws, but at least they allow you to compare these flexible managers with one another.
So what’s the right way to think about style purity? If you want a small-cap fund, the key factor is how small the fund is, not how small its stocks are. I’d advise you to steer clear of small-cap funds with more than $3 billion to $4 billion in assets; beyond that, buying little stocks is a big headache. And you should favor small-cap funds that have stopped, or promised to stop, taking in new money. As far as value funds go, I wouldn’t fret too much about whether a manager is buying big cheap stocks or little cheap stocks — it’s the cheapness that matters. Of course, you can always do what I do: Put your money into index funds and forget about it. On the other hand, if you want to bet against the odds by hiring an active fund manager, then let him be active.
Jason Zweig, Your Money and Your Brain
Jason Zweig, The Devil’s Financial Dictionary
Benjamin Graham, The Intelligent Investor