Refining style analysis
In his June 12 commentary, "Using a blend to evaluate style," Ronald Surz raises a number of interesting points regarding the use of returns-based style analysis, or RBSA. While I agree with his view that RBSA can be a useful benchmarking tool and that its effectiveness is dependent on the set of benchmark style indexes used as the basis for the analysis, his comments as to what constitutes a good set of style indexes are off the mark.
Without getting too much into the science of regression analysis, the key to a successful RBSA is starting with a set of style indexes whose returns are mutually exclusive and exhaustive. If the indexes have return patterns that are too similar (a condition known as co-linearity) or the set of indexes does not represent the complete set of variables influencing the returns of a manager (a condition known as missing variable bias), the style weights (regression coefficients) assigned by the RBSA can fluctuate wildly with only slight changes in the time period used for the analysis.
Note the emphasis here is on the returns of the style indexes rather than their composition. Nothing in regression theory suggests that the "collection of securities classified should comprise the entire market" as Mr. Surz asserts. In fact, efforts to include every stock in the universe may weaken the effectiveness of RBSA to the extent that the inclusion of stocks with marginal characteristics reduces the distinctiveness of index return. Examples of style index families that exclude marginal stocks to improve the distinctiveness of index performance include the indexes constructed by Wilshire Associates and those by my firm, OakBrook Investments.
The OakBrook Style Indices also feature a unique method for classifying stocks based on the variability of a stock's past return behavior that serves to accentuate the distinctiveness of return behavior and improve RBSA results. The OakBrook Style Indices are available through the Zephyr Associates Style Advisor and can be used easily in RBSA via a pre-defined user template.
director of research
OakBrook Investments LLC
Merton Miller and LBOs
With all due respect to Professor Eugene M. Lerner, it is not correct that the late Merton H. Miller's theories "certainly provided the basis" for 1980s leveraged buyouts, as he asserts in the June 12 article, "Merton Miller remembered as `champion of free markets.' "
In his acceptance speech for the 1990 Nobel Memorial Prize in Economic Sciences, Mr. Miller specifically disavowed credit for inventing LBOs, noting they were part of the corporate landscape long before he and Franco Modigliani published their first paper on financial leverage in 1958. "That Franco Modigliani and I should be credited with inventing these takeovers is doubly ironic," he added, "since the central message of our M&M propositions was that the value of the firm was independent of its capital structure."
The "corporate junk-bond explosion that began in the 1980s" is another phenomenon that cannot truly be attributed to the Miller-Modigliani propositions. Speculative-grade debt, including both high-grade issues that had declined in quality and new issues rated less than triple B, long antedated the pair's 1958 paper. John Moody used the more polite term "high-yield bond" at least as early as 1919. Arthur Stone Dewing initiated scholarly study of the securities at the Harvard Graduate School of Business Administration in 1923. Academic theories, however, had little to do with the "explosion" in new issuance that started in 1977 and accelerated during the succeeding decade. The more direct cause was the mutual fund industry's introduction of specialized high-yield bond funds, which greatly increased the demand for lower-rated issues.
Merton Miller deserves to be memorialized as one of the greatest financial economists. The clarity of his logic, combined with a sardonic wit, made his writings a joy to read. Above all, Miller strove relentlessly for accuracy in his work. In that spirit, he doubtlessly would have deflected Professor Lerner's well-intentioned accolades.
chief high yield strategist
Merrill Lynch & Co.