Investment Manager Style Analysis – what is it? Here’s a clear explanation of style analysis and the two reasons why investment manager style is critically important to 401k plan sponsors.
Our Investment Due Diligence process places an important emphasis on an investment manager’s style, employing a technique called “quadratic optimization.”
Quadratic Optimization” is a big word, and even bigger mathematical equation, which basically calculates the style of an investment manager, reflecting how the investment behaves, or what segment of the market the investment manager best represents.
Most money managers have a unique investment philosophy that decidedly places them in some segment of the equity or fixed income marketplace. The U.S. equity marketplace has some of the most numerous and varied investment managers, whose focus can range from large company stocks to small company stocks.
For companies of any size, their stock prices may be considered to be “value” (companies with low prices relative to various accounting measures) or “growth” (fast growing companies with high growth rates). Many investment managers may also reflect what is called a “blend” style, which means they invest in both “value” and “growth” companies.
Significance of Investment Manager Style Analysis
Investment Manager Style Analysis is important to 401k plan sponsors for two critical reasons.
First, it helps us determine whether a 401k retirement plan is well diversified among its various investments. At the most basic level, it is important for participants to have investment exposure in a broad array of asset classes, from U.S. equity and international equity to fixed income.
Understanding an investment manager’s style within these asset classes allows the 401k investor to be well diversified, or said another way, not have “all of his or her eggs in one basket.” For some asset classes, such as U.S. equity, there is often a greater level of analysis that needs to be done to determine the diversification among the different styles.
Secondly, style analysis helps us determine manager skill. Without style analysis, we would not be able to tell with any certainty if a certain benchmark is correct for a particular investment manager, or if that manager is being classified in its most appropriate area.
A well performing small cap manager may look attractive against the S&P 500 Index (a large cap benchmark), but analyzing him more closely, against an appropriate small cap benchmark, may lead to the conclusion that the manager has done a poor job selecting small cap stocks (due to the manager’s “relative” performance).
Indeed, measuring an investment manager against their most appropriate benchmark helps us find the most skilled managers in their respective categories. If you’d like to learn more about applying style anaysls in evaluating your 401k investment options, please contact us.