by Cynthia Harrington

In down markets, advisors are pressured to find an edge to help investors.

Finding asset managers that can outperform the market indexes is one solution, but this is no easy task. Study after study concludes that few managers beat the proxies year in and year out. But with sharper tools, some advisors cut away the hype to find that small minority of asset managers who can, and do, outperform.

The tools, called returns-based and holdings-based style analysis, are widely used by advisors looking for active managers. Personal financial counselors at Ernst & Young belong in this camp. “Philosophically, we’ve always pursued superior active managers for clients,” said Richard Joyner, CPA/PFS, CFP, CIMA, and the personal financial counseling area director for Ernst & Young, in Dallas.

The trick is to find a way to identify managers who outperformed in the past - and which ones will continue to outperform in the future. Returns-based analysis measures and attributes performance to any number of selected benchmarks. The goal is to reveal the closest style and the relative superiority of the manager. This method is cheap and easy since performance results on funds and benchmarks are readily available. “Most people started using returns-based early because it was the first to be delivered through the software pro-viders,” said Joyner.

Zephyr’s Style Advisors provides returns-based analysis. And market data giant Ibbotson & Associates publishes research on the effectiveness of the method.

The 2002 report, “Do Winners Repeat with Style?” concluded that investors who invest in the top 5 percent of funds, when ranked by style-adjusted alpha, can reasonably expect their fund to repeat good performance, and that their fund may return an alpha in the 0 to 5 percent range in the next year.

Weighing in on the other side of the argument are holdings-based adherents. Using returns-based analysis and comparing managers to benchmarks is a crude start, they say, but one needs to analyze each holding to really understand the value added by a manager.

Ron Surz is president of San Clemente, Calif.-based PPCA, a provider of holdings-based analysis to investors.

“Returns-based might identify managers that have outperformed, but investors need to know why,” he said. “If the manager got lucky with an IPO or happened to overweight a winning sector in one period, it’s unlikely that the superiority will persist.”

Morningstar built its company on providing holdings-based tools. Through the Advisor Workstation and the Principia databases, advisors look at the actual holdings of funds. Each position is assigned an investment style. A client’s portfolio can be analyzed at the holdings level to determine concentrations in specific stocks, the true level of diversification within each class, and the picture of the actual style of each fund. Mutual fund data supplier Lipper also offers holdings-based analysis, including their Active Indices that provide aggregated peer group holdings data.

Geoff Balzano is senior product manager for The Advisor Workstation at Chicago-based Morningstar Inc. “Advisors receive a deeper, more sophisticated analysis if they know the holdings of funds,” said Balzano. “They not only get a more accurate picture of what the client owns, but they can track style drift from one period to another much more accurately.”

Critics of the holdings-based camp suggest that the analysis is useless because holdings data is not current enough. Mutual funds are required to update holdings only semi-annually.  “Ninety-six percent of fund families update holdings in our database at least quarterly and half of those update monthly,” said Balzano.

Morningstar also counters the returns-based research studies with one supporting the superiority of the competing philosophy. In “Estimating Portfolio Style: A Comparative Study of Portfolio-Based Fundamental Analysis and Returns-Based Style Analysis,” authors concluded that whether measured by correlation or absolute deviation, returns-based analysis produces significantly weaker results than does holdings-based analysis based on a one-year-old portfolio.

In the practical world, advisors usually use both methods. Each tool offers unique advantages at different stages of the portfolio management process. “Returns-based is a great place to start searching for managers to hire,” said Surz. “Assigning style and comparing to benchmarks is a way to get the list of possibilities down from 20,000 to a few hundred managers.”

Beyond the initial manager screening, returns-based offers presentation capabilities that its competitor does not. “We use the presentation reports from the returns-based software to illustrate our expectations to clients when setting up portfolios,” said Joyner. But holdings-based reports allow Joyner to shine with clients. With this tool, he can demonstrate to clients not just how well they did, but why. “With these reports, they get to see whether a manager is moving around trying to chase returns, or has added performance from one big lucky break, or is smartly adding value by overweighting in sectors that outperformed,” he said.

Joyner added that money managers prefer being evaluated by holdings-based analysis as well. Managers fear that being categorized by comparison to a style index in some reporting periods could be just a fluke. They really want to be evaluated on what they owned because their added value is in picking stocks and being in the right sectors at the right time. Joyner uses a PPCA holdings-based product called StokTrib.

Surz’s product pinpoints the reason for a manager’s ability to beat the indexes. Managers outperform due to superior stock selection, sector allocation, or being good at trading.

“Using these two methods is a little like building a table,” said Surz. “You can use rough tools to cut down the trees, but to smooth out the surface or carve decorative designs, you need more refined assistance.”

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