The Alpha Strike Zone
By Michael Finke
April 1, 2014
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Baseball legend Ted Williams famously created an outline of the strike zone and mapped his batting average in tiny boxes. He figured if he was going to bat .400, he needed to swing only at pitches in spots that gave him the best chance of a hit. Swing in too many of the low-average spots, he reasoned, and you won’t get into the hall of fame.
The difference between an all-star and a bench warmer is all about being in the right part of the strike zone.
Investors have known about mutual-fund style boxes for a long time, but few understand their purpose. Should an advisor identify the best fund in each of the boxes? Should they attempt to capture equal exposure to all styles?
It’s easy to find a single fund that provides exposure to all the boxes. Just pick a broad index fund with the lowest fee, and you’re set.
The debate over factor-based investing
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Your philosophy on the use of style boxes should depend on how you feel about the persistence of factor-based alphas. It’s old news that small-capitalization and value investing have outperformed historically in the United States and internationally1. That means investors should swing at pitches in the low and inside corner of the style box (small-cap and value) and let high and outside (large-cap and growth) float by.
This debate is also about cheating the corners within the style box. A smart fund manager who recognizes historical factor advantages might be tempted to let a fund drift to the lower-left of his or her style box. A large-cap growth manager has a better chance of beating the benchmark (a strike down the middle of the box) if he or she overweights smaller and more value-oriented securities. As long as the manager stays within the box, he or she looks like a genius (assuming the small-cap and value premia persist). Doubters can take up the argument with Eugene Fama and Ken French.
This all begs the question – why bother? If you’re building a portfolio of funds that provides the highest expected return for a given level of risk, then why not just select the best funds from the lower left box? Advisors get more hits (alpha relative to a market benchmark) if they swing at pitches that have the highest historical risk-adjusted returns.
1. There is little debate over the fact that value stocks have outperformed on a risk-adjusted basis.But a debate exists over whether the same can be said of small-cap stocks (see here).
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