With the release of Andrew Lo’s recent paper on a new way to calculate alpha, this article by Edhec on style analysis seems apropos. As you may recall, Lo argues that the true measure of active management is a manager’s ability to correctly forecast security price movements and to express those forecasts in the portfolio. The key metric, therefore, is the correlation between portfolio positions and price movements.
This is clearly a “holding-based” approach to analyzing manager value-add that differs from the traditional returns-based approach which infers the make-up of a portfolio from the way it responds to exogenous variables. The return-based approach was, of course, first popularized by William Sharpe late last century (for modern examples of such detective work, see this Amaranth case study or this Fidelity Magellan case study).
While return-based analysis is computationally easier, it has come under attack recently as a somewhat blunt instrument. In its place, the infinitely more granular holding-based approach has captured the limelight. To be sure, holding-based analysis is elegant and is being adopted by legions of funds of funds, and other institutional investors who have position-level transparency into the funds they own. But is it infallible?
VÃ©ronique Le Sourd says no. In fact, she argues for a return to the return-based style analysis of old. Her article “Return-Based Style Analysis: an answer to the difficulties of implementing Holding-Based Style Analysis” first appeared in the magazine Funds Europe last fall, but is now available without registration on the Edhec website. She says that while holding-based analysis can be much more precise in theory, it suffers from three fatal flaws:
- It requires extensive inputs (e.g. historical position-level holdings)
- It must be carried out regularly in order to account for changes to the individual securities and weightings
- The classification of each individual security can be subjective
In a former life, Alpha Male used to produce holding-based style analysis for institutional hedge fund investors. He still wakes up with nightmares about the monthly slicing and dicing that was the source of much consternation as his colleagues and he debated whether a certain stock was growth or value or whether it was truly a large-cap or was just a mid-cap temporarily on steroids.
Le Sourd addresses these problems head on:
“While a portfolio is not always completely growth or value, or large cap or small cap, or well balanced in each of its two dimensions, the rating agency has to put the fund in a specific category, in which it is not possible to consider the specific risks taken by the fund. As a result, the comparisons between the funds that belong to one of these categories are not reliable, as these funds do not share many characteristics. Considering the problems introduced in style analysis by this final categorisation, the criticisms concerning the R-squared value or the regressors used in the RBSA approach appear to be minor details.”
These “minor details”, Le Sourd says, can be easily addressed with some mathematical tweaking:
“…the main drawback of return-based style analysis, namely that the fund style is assumed to remain constant during the analysis period, can be circumvented in several ways. One method consists in performing rolling regression over successive sub-periods to get the evolution of fund style throughout the whole period.”
In the end, Le Sourd suggests that the nail in the coffin for holding-based analysis should be the fact that position-level data is not generally tracked by any of the major hedge fund databases. This means investors need to trust that the manager has performed this rather subjective analysis correctly.
– Alpha Male
As a footnote, this sounds like good news for providers of managed accounts platforms. After all, their core value proposition is the ability to slice and dice portfolios of many funds on a position-by-position basis.