Strategy Boxes

May 23, 2007

Can AthenaInvest’s new strategy classification tip the apple cart of Morningstar’s style boxes?

The style box method of classification may have a competitor on the horizon. The style/size grid concept has been used for years by the mutual fund industry—most notably Lipper and Morningstar— to classify funds for asset allocation purposes. However, AthenaInvest Inc., an offshoot of Janus funds, has been beta testing its own system for the past few weeks with the intention of a formal launch in July.

The impetus for the firm’s venture had its roots in the frustrations firm co-founder Craig Callahan experienced as a fund manager. Callahan is also founder and president of ICON Advisers. Some years ago, he ran into problems marketing a fund that didn’t fit into one of the predetermined style/size boxes and enlisted his former University of Denver colleague Tom Howard, co-founder, CEO and head of research at AthenaInvest, to examine the issue with him.

Dr. Howard’s study revealed that active managers sacrifice, on average, 300 basis points of performance in their efforts to remain true to their style/size category, a figure they say is backed up by similar studies from other sources. Drs. Howard and Callahan decided to find a way to accurately characterize a manager’s investment style without restricting him or her in the pursuit of alpha, and still give financial advisors a useful classification tool for asset allocation purposes.

“When managers are forced to stay in a box, it forces them to underperform because it restricts the choices they can make and it forces them to create sub-optimal portfolios,” says AthenaInvest President Wes Schrader. “We believe that active managers should be allowed to do what they do best, which is pursue alpha. And to do that they need the entire universe.”

Morningstar popularized the nine-box grid that is seen so often, although Lipper did introduce a 12-box grid. Morningstar’s vice president of research, John Rekenthaler, points out that Morningstar intended the nine-box grid to be used purely for descriptive purposes.

“It’s a tool for getting a gauge of how an individual fund fits into an overall portfolio context, with the words being ‘tool’ and ‘gauge’ as opposed to ‘rule’ and ‘prescription,’” says Rekenthaler.

The style boxes were originally something institutional consultants were using with their clients in the 1980s, although back then they were four-box grids with small-cap/large-cap and growth/value designations, according to Rekenthaler. Morningstar’s subscribers, mainly financial advisers, asked for something similar, and Morningstar eventually introduced the more complex nine-box grid.

AthenaInvest’s Schrader says the style boxes were a good idea originally and that they brought some much-needed organization to the mutual fund industry, providing financial advisors a way to sort through funds when developing their asset allocation models. However, over time, the style boxes evolved into something more constricting; AthenaInvest is seeking to reverse this trend.

Morningstar’s Rekenthaler disagrees. “That’s really the heart of a fundamental disagreement between Athena and Morningstar—that they say that portfolio managers are kind of terrified of Morningstar’s or someone else’s style boxes and are running portfolios in response to it. We feel that the vast majority of financial advisors understand the notion of the style box as a tool, that they’re not just dumping funds if they switch style boxes.”

The result of the AthenaInvest’s efforts is a strategy-based system that was arrived at through analysis of fund managers’ publicly stated objectives as found in compliance-approved documents like prospectuses and marketing materials.

“We haven’t seen anyone else look at these things in quite this way,” Schrader says. “We find that in those [documents], the managers tell us the majority of what we need to know in order to categorize them and understand what their strategy is. When we talk about strategy, we’re talking about the decision process—we’re taking a look at what are the key pieces that fold into a portfolio manager’s investment decision process.”

10 Strategy Boxes

AthenaInvest ultimately arrived at 10 strategy types. Because of pending patents, Schrader could not comment extensively on the selected strategies, but he offered an example. In the competitive position strategy category, a fund manager selects stocks based factors such as strong fundamentals, quality management and brand strength—all managers using this as their primary strategy are put into this peer group.

“We find when we categorize managers based upon those strategies and rate them according to consistency with those strategies, we’re able to give financial advisors much better tools for putting together portfolios that increase the possibility of capturing additional alpha,” Schrader says.

The platform AthenaInvest plans to launch in July will be targeted primarily at financial advisors but will also be useful to fund managers. “The platform that we’re beta-testing right now has the components in it that the financial advisors need to put together portfolios using our methodology. However, that same platform is also useful to fund managers, because what we’re doing to a certain degree is redefining the shelf space that’s available in the industry.”

With ten strategies as primary categories and then a sub-group classification for secondary strategies, Schrader says that shelf space amounts to roughly 90 possible designations. Indexes will be calculated for the ten primary strategies.

Morningstar’s Rekenthaler believes the classification system could be a nice complement to the style boxes, rather than a replacement. “If you take a classification scheme based on managers’ stated objectives, you now have some explicit measurement that you can use to say that a manager’s doing what he or she said,” says Rekenthaler. “I think they’re highlighting some useful information.”

Another advantage that Rekenthaler cited was the system’s flexibility, but he also noted a couple of disadvantages, pointing out that different managers might have different interpretations of objectives that nonetheless use the same wording or language. He also notes that AthenaInvest’s system is not necessarily all-encompassing should a new fund with a unique set of objectives arrive on the scene.

“If you go by publicly stated objectives it’s not clear that there’s a place for everything. It’s not set up from the beginning to be a complete system that you can drop everything into,” he adds.

Rekenthaler says that Morningstar already discusses fund strategies in the analysis parts of its reports. “I would suggest we are doing something similar, it’s just not organized in the same way that they are doing it,” he says.

Interestingly, index funds fall outside AthenaInvest’s classification system, although they are still considered an important part of a portfolio’s construction. The strategy designations are for the active portion of a portfolio only. According to AthenaInvest’s Strategy Based Investing methodology, index funds are used to adjust the portfolio’s tilt—to a particular market cap size or sector, for example—after the active part of the portfolio has been established. AthenaInvest’s research shows that a portfolio of active managers following diverse strategies results in fairly constant portfolio tilts over time, Schrader says. Style-based index funds could even be used to tilt a portfolio toward a certain P/E range, Schrader added. AthenaInvest’s objection to the “style” concept applies more to its use in the classification of active funds than to the idea of style-based investing.

The product launching in July will offer subscribers a web-based platform covering U.S. open-ended equity mutual funds, and will include strategy classifications, a rating system in which funds are rated a number of diamonds according to how closely they track their designated peer groups, and tools to construct a portfolio based on AthenaInvest’s Strategy Based Investing methodology, Schrader says. The firm expects its customer base to include financial advisors and asset managers.

Will It Succeed?

The style box concept is entrenched in the mutual fund industry, and AthenaInvest is a small firm facing an uphill battle if it intends to replace it. However, Schrader says it hopes to bring about a significant shift in the mutual fund industry, changing the way funds are viewed and the way fund managers invest.

“We are facilitating a paradigm shift in the industry. Active managers adopting our paradigm will be free to pursue alpha wherever they can find it in U.S. equity. The manager will always be able to add his or her best picks to the portfolio without market cap or P/S constraints. This is possible because the Strategy Based Investing paradigm focuses on how a manager got to a chosen portfolio.”

Rekenthaler, however, believes AthenaInvest’s position is a bit extreme. “We’ve pointed out that many of the biggest and most successful funds in the industry have over time moved among different Morningstar style boxes and that doesn’t seem to have hurt their popularity. It doesn’t seem to have crushed their portfolio managers into submission,” he notes.



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