January 07, 2002

The present market correction presents us with an interesting opportunity to look at the interaction between the size and style. It also provides us the opportunity to identify other biases that may undermine a portfolio manager's performance. We posit that, during the correction, the previous spurious correlation between size and growth will weaken substantially and may even reverse. But there is more to the story. The question in our minds is what if the earnings decline is temporary? Then it would be inappropriate to switch the company from the growth camp to the value camp. It is this possibility that has us concerned. To the extent that some of these stocks are misclassified they will introduce systematic biases to the relative performance of the style indices. The biases are two-fold. First, stocks that are truly growth companies will be eliminated from the universe of growth managers thereby reducing their diversification and quite possibly their return potential. On the value side there are problems too. The stocks being added to the value universe may not really fit a broader definition of value, making it less likely that they will be included in their universe/portfolio. The practical implications are fairly straightforward. The opportunity set for both value and growth institutional money managers will be reduced if they stick to their usual value and growth metrics. This systematic bias will make it more likely that they will under-perform their benchmark. If, on the other hand, they change the metrics to allow for the inclusion of the newly (i.e., temporarily) reclassified stocks, these managers will open themselves to future accusations of style drift or plain violation of their style. (full article attached)

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