Investments, tenth edition

   Style Analysis and Multifactor Benchmarks 

 Style analysis raises an interesting question for performance evaluation. Suppose a growth-

index portfolio exhibited superior performance relative to a mutual fund benchmark such 

as the S&P 500 over some measurement period. Including this growth index in a style 

analysis would eliminate this superior performance from the portfolio’s estimated alpha 

value. Is this proper? Quite plausibly, the fund’s analysts predicted that an active portfolio 

of growth stocks was underpriced and tilted the portfolio to take advantage of it. Clearly, 

the contribution of this decision to an alpha value relative to the benchmark is a legitimate 

part of the overall alpha value of the fund, and should not be eliminated by style analysis. 

This brings up a related question. 

 Chapter 11 pointed out that the conventional performance benchmark today is a four-

factor model, which employs the three Fama-French factors (the return on the market 

index, and returns to portfolios based on size and book-to-market ratio) augmented by 

a momentum factor (a portfolio constructed based on prior-year stock return). Alphas 

estimated from these four factor portfolios control for a wide range of style choices that 

may affect average returns. But using alpha values from a multifactor model presupposes 

that a passive strategy would include the aforementioned factor portfolios. When is this 

reasonable? 

 Use of any benchmark other than the fund’s single-index benchmark is legitimate only 

if we assume that the factor portfolios in question are part of the fund’s alternative passive 

strategy. This assumption may be unrealistic in many cases where a single-index bench-

mark is used for performance evaluation even if research shows a multifactor model better 

explains asset returns. In Section 24.8 on performance attribution we show how portfolio 

 Figure 24.9 

Average tracking error for 636 mutual funds, 1985–1989  

 Source: William F. Sharpe, “Asset Allocation: Management Style and Performance 

 Evaluation,”  Journal of Portfolio Management,  Winter 1992, pp. 7–19. Used with per-

mission of Institutional Investor, Inc., www.iijournals.com. All Rights Reserved. 

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Average Tracking Error (%/month)

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Final PDF to printer

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P A R T   V I I

  Applied Portfolio Management

managers attempt to uncover which decisions contributed to superior performance. This 

performance attribution procedure starts with benchmark allocations to various indexes 

and attributes performance to asset allocation on the basis of deviation of actual from 

benchmark allocations. The performance benchmark may be and often is specified in 

advance without regard to any particular style portfolio.