The Implications of Style Analysis for Mutual Fund Performance Evaluation

Consider the child's game tic-tac-toe. There is simply no way to win, even if a genius is playing against an opponent of only moderate intelligence. Each player, in turn, simply blocks the other player's previous move. (Of course, if one player is dull-witted or bereft of the power of concentration, a loss is easily accomplished.) In short, as a game that cannot be won, only lost, tic-tac-toe is the ultimate loser's game. Curiously enough, the new Morningstar Category Rating System is played on a field with a pattern identical to tic-tac-toe. Because of this similarity, the nine-box system for analyzing fund investment styles raises, perhaps inadvertently, the question: Does the search for fund performance resemble the search for three Xs (or Os) in a row in a child's game? Put another way, if no one can win consistently when nearly all participants have at least average skill, is not fund selection, too, a loser's game? This analogy quickly brings to mind one of the truly seminal articles about the challenges of investment management in increasingly efficient financial markets. Written by Charles D. Ellis, founder of Greenwich Research Associates, and published in the July/August 1975 issue of The Financial Analysts Journal, it was called, of all things, " The Loser's Game. " In his article, Mr. Ellis observed: " The investment management business is built upon a simple and basic premise: professional managers can beat the market. That premise appears to be false. The ultimate outcome (of the game) is determined by who can lose the fewest points, not who can win the most. Money management has been transformed from a Winner's Game to a Loser's Game." When the article was written—now more than two decades ago—the Standard & Poor's 500 Index was virtually the only standard used by institutions to measure market returns. (Even it wasn't used very often!) And in those ancient days, the portfolios of most institutional managers—and most mutual funds— were dominated by a blended list of the large cap stocks in the Index. In this modern day and age, however,