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Break Out the Box Cutter

by Mike Trapanese

In my life outside of distribution consulting, I play the saxophone. John Coltrane has been an inspiration for me. Generations of jazz musicians have tried to emulate his style of improv by applying music theory to his solos. As it always does in music, however, the theory eventually became a thing unto itself. I'll never forget watching a music teacher throw his finger onto the page of a transcribed Coltrane solo to point out a "wrong note." Since I've constantly got sax on my mind, I've come to realize that lumping mutual funds into style boxes is much like evaluating Coltrane based on music theory.

Morningstar style boxes have their merits. As a classification system, they are an effective way of grouping funds for reference. As a marketing tool, they present an intuitive way to describe funds to advisors. They are, however, an inductive overlay and can be limiting from a product development standpoint.

Research analysts at broker-dealers are a more savvy audience than their advisor colleagues. Increasingly, the responsibility of picking funds is being transferred to these analysts as more and more assets pass through discretionary platforms every year.

These gatekeepers are more discriminating in their selection processes. In contrast to many advisors, they understand pure alpha and actively seek it. To differentiate their products in the eyes of analysts, product developers should look to build products around successful strategies rather than style boxes.

Morningstar gives style drift a bad rap because it undermines the integrity of their peer groups. Quite often, however, "drift" drives returns as part of a manager's investment strategy. This "drift" is the wrong note in a Coltrane solo. Thus the problem is not style drift-- but it could be the style box itself. The omnipresence of these boxes has blurred the line between strategy and style box. Building products around style boxes is a reliable way to ensure beta, but at the same time it is a sure-fire way to undermine the benefits of a successful strategy.

Building a fund product from the strategy up, without consideration of the style box it will occupy, comes with consequences. Invariably, returns will deviate from their benchmark. To communicate this paradigm shift to research analysts, Athena has developed a classification platform that groups funds by common strategy elements rather than common holdings. Examples of these strategy buckets are Economic Position, Future Growth, and Profitability. We at kasina have already started to hear research analysts talking about Athena's SBI platform.

It's important to remember that style boxes are a limiting force, and trying to stick within their walls is bound to limit alpha and drag returns towards the benchmark. Similarly, John Coltrane didn't rip legendary solos by staying within the confines of music theory -- he first understood the theory, and then understood those instances in which he had to surpass it.