Summary

We use style analysis to assess whether fund managers are “true to label” and, just as importantly, how strongly their investment style influences their returns.

This allows us to contrast different managers quickly and efficiently, and also to construct portfolios with the exposures we want.

Selecting funds

In our diversified portfolios the bulk of the investments is through managed funds. We divide the portfolio into asset classes and sub asset classes, each of which has a strategic asset allocation weight that we vary dynamically as markets change.

For most sub-asset classes we use managed funds to gain exposure. When selecting a fund we face a problem: there are thousands of funds operating in the marketplace, often with very similar sounding processes and philosophies. Almost every fund says they invest in higher quality assets than the market at lower than average prices, so how to we determine which fund managers are most likely to give us the exposures we want in the portfolio?

Research ratings are helpful in determining a short list of managers that are well regarded and have appropriate systems and processes. But we don’t find research ratings very useful for working out which manager is the best one to
implement our views or how much to allocate to each fund. The most effective tool that we have to answer those questions is style regressions.

These allow us not just whether a manager has been consistent with their stated style and process but also how much of that style they bring into the portfolio. And unlike the marketing collateral, we can see substantial differences between funds when we look through this lens.

Below we show you a simplified example of how we applied this process to Australian equity managers in our review at the start of the quarter.

Factor regressions

We regress the returns of the selected funds using the Fama-French factors for Australian equities that are published by AQR. (We also use other sets of factors, but for this example we’ll keep it simple and stick with the one
factor set.)

The factors are market neutral, so when we regress the funds’ returns against the factor returns they divide the funds’ returns into the market component, differences from the market return that are attributable to the factors, and any returns that aren’t explained by the factors (the “non-factor” return.) Non-factor returns represent returns that cannot be explained by factors (i.e. alpha) or rotation between factors during the period. Non-factor returns have been converted to an annual percentage.

Because we’re looking at long only funds in the analysis below we’ll omit the market factor, which is always close to 1, and focus on style factor returns.

The benchmark returns below show that the style benchmark indices typically have a loading of 0.25 – 0.5 on the relevant factor, so 0.3 is a strong exposure. Quality and value are negatively correlated, so the returns of the value index are explained by both a negative loading on quality and a positive loading on value. The small cap index has a positive loading on quality and size, as many small companies are fast growing businesses with clean financial histories. There is no Fama-French growth factor. Instead, growth exposure is proxied by quality and negative loading on value.

Aequitas

Looking first at Aequitas’ model portfolio investments, we see that the Aequitas Core Equity Portfolio has a strong quality loading and a negative loading on value. The portfolio focusses quality companies with valuation as a secondary consideration, so this is consistent with the portfolio’s style.

IML Concentrated and Allan Gray are both value managers that aim to purchase higher quality companies at lower than average valuations, but the analysis shows that IML Concentrated’s quality bias is stronger than its value tilt. Allan Gray manages to capture the value exposure without a strong negative quality exposure. Both funds have a negative tilt to momentum as both funds have a somewhat contrarian process.

Pengana is a small cap manager that focuses on the quality end of the small cap universe, and the style analysis bears this out. Vanguard is an index manager, and so it has little in the way of factor exposures.

Core managers

Turning to other managers with a core style, we can that many have no positive loadings to style factors. Where loadings are low (less than 0.1) this reflects a fund which is very close to the benchmark. We do not generally invest in these funds as the exposure can be obtained more cost effectively though index funds.

Many of the funds with strong factor exposures have a significant loading to the size factor. This indicates that they invest in smaller companies, which is becoming a common way for active managers to boost returns. We prefer to obtain our exposure to smaller companies through dedicated small cap managers who specialise in this area.

Few funds have evidence of persistent non-factor returns (or “alpha”) after accounting for factor exposure, which could be evidence of successful style timing or superior stock selection. Those that do, such as Bennelong, tend to have had a very strong sector concentrations. To assess these funds we review their history of changing positions and determine what level of exposure would be appropriate given the risk of a fund underperforming in any given period – bringing idiosyncratic manager risk into the portfolio makes it harder to reliably the returns of the portfolio even if long term returns are good.

Macquarie Australian Shares has a high non-factor score that is statistically significant, but closer analysis showed that this was due to the fund changing the entire team and investment process from high conviction fundamental to a systematic quant process in 2017, which led to a significant change in factor loadings at that time. We cannot consider this evidence of skill at timing markets – it is unlikely to be repeated.

Value managers

Most value managers have significant exposures to the value factor. Most value funds also have significant negative loading to momentum, which is to be expected as they invest in stocks that have underperformed the broader market. Typically value funds have a negative quality loading as well, as companies that are cheaper generally have poorer financial metrics.

Allan Gray, Dimensional Australia Value and Lazard Select have the strongest value exposures at around 0.3 each, however Allan Gray is the clear standout with no negative quality or non-factor exposure.

Dimensional has low fees but its value exposure is mirrored by a negative quality exposure. This is a reflection of the fund’s systematic process.

Lazard Select has a quality exposure that is below the usual threshold for statistical significance but still probably not due to random chance. However, the fund has a large negative non-factor loading that is also unlikely to be random chance, which is evidence that the fund’s stock and sector timing has subtracted value.

As noted above, the Investors Mutual funds actually have a stronger quality bias than value, so we regard them as primarily quality funds.

Conclusion

Style analysis allows us to quickly and consistently compare funds to find investments that have the exposures we are targeting in our portfolios, and help us to determine the appropriate holding size for each one.