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Attributing fund return to style

In the US mutual fund arena, style is becoming an ever more important element of fund analysis. Some fund-tracking companies now classify funds by their investment style rather than by their stated objectives. They do this by looking at the underlying portfolio of a fund and attributing classifications to these stocks (large cap, growth, etc) dependent upon their characteristics.

Standard & Poor's will be releasing a US mutual fund ranking system classified by style, using Micropal data. There are a number of advantages to grouping funds by style. Firstly, it is more efficient. Analysing the underlying stocks in a portfolio requires far more resources than style analysis and provides no more accurate results. As a result style analysis can be done more than once or twice a year. Secondly, it uses identified and agreed definitions of the different styles (ie, value or growth) rather than the arbitrary attribution of labels to individual stocks.

So what is style analysis, and how does it help with the analysis of investment portfolios?

In very simplistic terms, style analysis uses a set of benchmarks to identify the combination that best fits the behaviour of the fund. For example, the style history of the Legg Mason Value fund, a leading US equity fund in terms of performance, shown in the chart, indicates that, based on a trailing window of 36 months, this fund has been largely invested in large-cap value stocks, although up to two years ago a significant proportion of its assets were behaving like medium-sized growth stocks. Until the end of last summer, a growing part of the portfolio was behaving like small value stocks. Nevertheless, during 1997 a growing part of the portfolio has also been behaving like large-cap growth. This does not necessarily imply that the fund has been buying growth stocks, just that some of the holdings have been behaving as if they were. This can occur for a number of reasons, not least of which is the fact that when the manager purchased the shares in these companies, they met his value criteria", ie, relatively undervalued to assets, high earnings growth potential, etc . Subsequently they may have changed, but the managers believe that this change may be temporary and therefore there has not been a significant reason to sell.

Style is important in relation to the actual stock or market selection. Style has been key to the Legg Mason fund's record, responsible for 83% of returns, whilst actual selection has been much less vital, accounting for 17%. The style contributed the bulk of the fund's performance and volatility. Stock or market selection used by the fund has contributed three times the level of volatility in relation to its contribution to the fund's return.

We can also evaluate the changing relationship between the fund and the style indicators that we have used. This shows how relevant the overall analysis is. In this case the relationship between the fund and the key benchmarks is high, suggesting that the analysis is reasonably accurate, and how this relationship has changed.

Finally, the style map allows us to view how the fund's overall style has evolved over time. The style map for Legg Mason Value tells an interesting story. Firstly, the fund appears to have been invested primarily in larger capitalisation stocks. Secondly, the value/growth emphasis has moved slightly. At the start of this analysis, the fund seemed to be holding a slightly higher weighting of growth rather than value stocks, but over the last three years the fund has been increasing its allocation to value stocks - or, at least, the fund's investments have been behaving more like value plays. So far in 1997, however, it appears that the fund's portfolio has been holding a larger amount of growth stocks, and this reinforces what we saw in the style history chart.

The mean position in our analysis shows that the fund has had an overall style of "large-cap blend" - the mean position is too central for the fund to be pure value. This highlights the difference between the classification of funds by objective and by style. This fund aims at capital growth using the "value approach" to investing (the purchase of securities that appear undervalued in relation to the long-term earning power or asset value of their issuers). In objective it is a growth fund (ie, the appreciation of capital), by stated style it is a value fund and by style analysis it is a "large-cap blend" fund.

Obviously, there is an issue of semantics as well as definitions. Ultimately, we have to evaluate the benefits to the investor. Value stocks have outperformed growth stocks in the US in the past 22 years. David Masters is with Micropal in Boston"

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