Dr. C. Thomas Howard of AthenaInvest included an interesting nugget about style boxes in a recent article at Advisor Perspectives.
A few years ago we conducted an extensive research trying to identify who launched the style grid. As part of this research, we spoke with Russell Investments who provided information for what we believe was its initial launch. In 1984, the number of active equity funds was exploding and Russell was casting about for ways to categorize funds so that advisors and investors could make sense of this bewildering array. They tapped Bill Sharpe to help them address this problem. During a brainstorming session, Sharpe, as business faculty are wont to do, wandered to a chalkboard and drew a two-by-two matrix.
As all good academics believe, business challenges – no matter how complex the finance, marketing, or management issues they involve can best be summarized in a two-by-two matrix. Since small-firm and low-PE effects were all the rage in 1984, he proposed the axes be market capitalization and the average PE of the stocks held by the fund.
Thus was born the style grid.
It was launched that year, and Russell was stunned when, by the following year, the investment industry identified “style drift” as a serious problem for active equity mutual funds. They knew there was no research behind the style grid; it was simply put forward as a way to organize the growing array of funds. But the law of unintended consequences had already taken effect.
Even more amazing, the style grid is inferior to randomly forming fund peer groups. That is, funds within a style box pursue widely differing strategies as Dodson observed.
Again, it is hard to imagine a worse system than the style grid.
AthenaInvest, as you might imagine, categorizes managers by strategy rather than by style box, but I just thought it was interesting how something off the cuff gained a cult-like following in the industry, even when it doesn’t work.
Certainly, the style box is not the only cult item that has gained a following on Wall Street. The Efficient Market Hypothesis and Modern Portfolio Theory are at the top of my list. Not to mention this recent nugget from an article on the Dogs of the Dow:
…the most popular dividend-stock strategy among retail investors is the Dogs of the Dow, which calls for buying and holding the 10 stocks from the 30 in the Dow Jones Industrial Average with the highest dividend yields as of each Jan. 1.
The strategy took the investment world by storm in the early and mid-1990s, on the strength of both its simplicity and excellent long-term track record — at least when back-tested.
A funny thing happened on the way to the bank, however: In real time since then, the strategy has failed to keep up with a simple index fund. For example, the strategy has beaten the Dow itself in just 5 of the last 15 calendar years. And those five winning years have not come close to making up for the losses incurred in the 10 losing years.
Style boxes, MPT, Dogs of the Dow are all relics. They should be exhibits in a frontier museum, where you can point to them and say “look how the old-timers used to do it!” The story of the style box shows just how random some of the ideas are—and it’s not that they were bad ideas at the time. To advance any field, you need to brainstorm and throw ideas out there and test them. But when they can be shown not to work or when there are better ways to move forward, let go of it for goodness sake!
