Should the Morningstar style box go 3-D? Quality counts, says Atlanta Capital

Investment professionals and financial advisors are familiar with the Morningstar style box, which categorizes stock funds by market capitalization and style. A recent CFA Magazine article made me wonder if Morningstar should turn the style box into a style cube by adding a third dimension: quality.

Stock quality may overwhelm size and style

Quality counts for just as much as size and style.

That’s according to Brian Smith, director of institutional services and principal at Atlanta Capital Management, in “3-D Investing” in the Sept.-Oct. issue of CFA Magazine. The CFA Magazine article is based on a longer white paper, “The Third Dimension: An Investor’s Guide to Understanding the Impact of ‘Quality’ on Portfolio Performance.” To access the original white paper, click on “Publications” across the top of the Atlanta Capital website.

“…our research indicates that ignoring quality and investing solely by capitalization and style dimensions is unwise. In fact, the performance of high- and low-quality stocks can have a significant influence on an investor’s risk and return characteristics, in many cases overwhelming the influence of either size or style,” writes Smith in his CFA Magazine article.

I wondered if there might be something other than quality at work.  Could one style be more associated with quality than another?

Smith notes in the white paper that certain value and growth styles are sometimes associated with high- or low-quality stocks. “Conservative growth” and “relative value” tend toward high-quality vs. low-quality for “absolute value” and “aggressive growth,” he says. Smith refers to this as a “hidden quality bias.”

Smith compared returns by quality, size, and style using Russell indexes and custom benchmarks based on the Standard and Poor’s Earnings and Dividend rankings. Looking at 2009 returns, he found that “Clearly, each size, style, and quality index responded differently to the same economic stimuli….”

In other words, the correlations among the quality, size, and style indexes were weak.

The “quality cycle” in the stock market

Smith suggests that a “quality cycle” exists because fluctuations in the performance of high- and low-quality stocks are associated with the economic and stock market cycle. Low-quality stocks briefly outperform high-quality stocks at both ends of a market cycle. This is probably because they’re more sensitive to the economy, the availability of credit, and investor speculation. High-quality stocks win the rest of the time.

Smith concludes,”If history is a guide, high-quality stock should post stronger relative returns in 2010 and 2011….”

Do you agree? You’ll probably want to read more of the CFA Magazine article or Atlanta Capital white paper before you decide.

To GIPS or not to GIPS in your presentations

Must every presentation you give include the seemingly endless GIPS disclosures if your investment management firm claims GIPS compliance? For answers, I turned to Dave Spaulding,  president of The Spaulding Group and author of the Investment Performance Guy blog.

The short answer is “It depends.” When you hand someone a document containing performance data, you should either include the relevant GIPS disclosures or make sure that you’ve provided the disclosures during the past 12 months. There’s no exception to this rule. 

However, you’ve got more leeway when you make a live, in-person presentation to prospects or clients. You can’t mislead your audience. But you don’t need to include all of your GIPS data and disclosures in your live presentation. The keys are to
•    Provide enough information that your viewers understand what they’re seeing
•    Label as “supplementary” any performance information that is neither required  nor recommended
•    Hand your audience members a hard copy of your GIPS presentation

If you follow these rules, your presentations can focus on what you and your audience care most about. By the way, Dave’s presentation to the Boston Security Analysts Society on fixed income attribution was one of the top-drawing posts on my blog in 2009, so I thank him for helping to grow my audience.

Related posts
•   What does GIPS verification mean?
•   A quant’s guide to detecting a future Madoff
•   Top five tips for investment performance advertising
•  SEC update to CFA Institute’s GIPS conference
Susan B. Weiner, CFA
If you’re struggling to pump out a steady flow of good blog posts, check out my five-week teleclass for financial advisors, “How to Write Blog Posts People Will Read,” and sign up for my free monthly e-newsletter.
Copyright 2010 by Susan B. Weiner All rights reserved

Fixed income attribution week

I just learned that the Spaulding Group, which I wrote about in “Fixed income attribution falls short,” will run a week-long series of webinars on fixed income attribution from July 13-July 17, 2009.

If you remember the Campisi model that popped up in my earlier blog post, “Fixed income attribution falls short,” you may enjoy hearing the model explained by Steve Campisi himself in one of the Spaulding webinars. If you attend, please comment on my blog to tell me what you learn!