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Evaluating Style Analysis

By Frans A. De Roon, Theoe. Nijman and Jenke R. Ter Horst


In this paper we analyze the use and implications of (return based) style analysis. First, style analysis may be used to estimate the relevant factor exposures of a fund. We use a simple simulation experiment to show that imposing portfolio and positivity constraints in style analysis leads to significant efficiency gains if the factor loadings are indeed positively weighted portfolios, in particular when the factors have low cross-correlations. If this is not the case though, imposing the constraints can lead to biased exposure estimates. Second, style analysis may be used in performance measurement. If the actual factor exposures are a positively weighted portfolio and if the risk free rate is one of the benchmarks, then the intercept coincides with the Jensen measure. In general, the intercept in the style regression can only be interpreted as a special case of the familiar Jensen measure. Third, style estimates may be compared with actual portfolio holdings. We show that the actual portfolio holdings will in general not reveal the actual investment style of a fund because of cross exposures between the asset classes and because fund managers may hold securities that on average do not have a beta of one relative to their own asset class. Although return based style analysis is less suitable to predict future portfolio holdings, our empirical analysis suggests that it performs better than holding based style analysis in predicting future fund returns

Topics: Key words, Style Analysis, Mutual Funds JEL classification, G11, G23, C52
Year: 2004
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