New fund categories can be puzzling to investors
Well over a decade ago, I got a note from an investor who said he did not understand how average investors were supposed to keep up with “recommended behavior for fund investors.”
By his reckoning, Morningstar Inc., the leading fund research firm, had developed a style box that broke the world into nine categories for stocks, and another nine for bonds. There also were a few categories outside of the box.
Properly diversifying meant two funds in each style box, then at least one from every other category.
“How is any investor expected to pick and then keep track of more than 40 funds,” he wondered.
They weren’t supposed to invest that way then, or now, and I was reminded of the story this week when Morningstar introduced two new fund categories, foreign small/mid-cap blend and India equity.
An investor who didn’t know better might think that if a company like Morningstar has decided that these fund types have enough issues to warrant their own asset grouping, it means that the average investor should go out and get a representative from the class.
Nothing could be further from the truth.
“The reason we create so many categories of funds is to more closely compare like funds, and to make sure that the groups of funds we are comparing really are similar, so that the comparisons are most clean and effective,” said Gregg Wolper, senior mutual fund analyst at Chicago-based Morningstar (MORN). “We don’t want people to buy funds from every category, and no one should think that just because we have added a new category means they should go out and buy something from it, or that we are recommending funds from it.”
Typically, Wolper said, Morningstar likes to create a new category once there are about 20 funds to be grouped by asset type or specific investment style. Up to that point, existing funds are kept in the category that most closely fits what they do; at some point, however, a bunch of slightly misplaced funds muddies the ratings picture and necessitates change.
“If there are a handful of funds, well, being in the 20th percentile doesn’t say much when you are one fund out of five,” Wolper said, “and if we waited until there were 40, 50 or 100 funds for the new group, then the category they were in would have problems, and investors couldn’t be sure the comparisons were real. With about 20 funds, there’s enough interest from fund companies that it makes sense to break out with a new category.”
The growth of fund categories – whether it is from Morningstar, Lipper Inc. or any data provider – is a reflection of what fund companies themselves are doing, namely coming up with different ways to serve up the investment world.
Think of it like the famous 31 flavors of Baskin Robbins ice cream – one for every day of the month – where every choice represented a different taste, but you didn’t need a scoop of every single flavor to make a good sundae. A few flavors – based on how you are feeling, the taste you crave, trying something new – is sufficient.
So it goes in mutual funds, where a financial sundae that contains every flavor would have too many funds for the average person to properly digest.
What you hear about every new type of fund and asset class is that it is somehow “improved” or “better” than what is out there. What is hard to know is how all of these funds actually work together, whether owning a “large-cap growth fund” and a “core growth fund” gives you real or faux diversification, the former being valuable and the latter providing a false sense of security when both issues own mostly the same thing.
The point here is that as the fund world gets increasingly complex, coming out with new metrics, products and research tools, investors shouldn’t feel compelled to follow suit.
It’s akin to the portfolio of Morningstar president of mutual fund research Don Phillips, who in 2009 acknowledged that his holdings included more than five-dozen funds, but who at the same time said that investors could thrive with potentially as few as one fund “if it’s the right fund” – he was talking about life-cycle funds built to be do-everything options – and who has always maintained that a well- diversified portfolio can be built with anywhere from four to 12 funds.
Wolper acknowledged that the new categories are much more for the pros than the average fund shareholder.
“There are definitely people who have an idea about, say, India and who want to know the best funds investing there, so having a category that gives a real and honest comparison of those funds is good,” Wolper said, “but if the average person never buys an India fund, they probably won’t miss it. ... You don’t need to have a fund in every style box or every category, and that won’t change no matter how many categories we have to create.”
Chuck Jaffe is senior columnist for MarketWatch. He can be reached at firstname.lastname@example.org