Category Selection Heats Up
October 1, 2001
In a market downturn, when few funds are performing spectacularly if even well, the best managers may be able to do is beat each other. The category that a fund is placed in by fund trackers like Morningstar and Lipper becomes even more important, as firms seek return figures above zero by being above their counterparts.
In its fund Quicktake' reports, Morningstar lists the performance of a fund and that performance relative to the other funds in its category and an index. When the market is soaring and everyone can boast 20% returns, companies can advertise those numbers. In tougher times, however, a fund's outright performance may not be as marketable as its performance relative to the competition.
It's All Relative
For example, T. Rowe Price recently advertised in Mutual Funds magazine that its equity income fund ranked number 1 out of 19 equity income funds since its inception, although the advertisement oddly did not mention what that return was. The ad also compared the fund to Lipper's equity income funds average for one, three and five years.
When financial publications review the Top Funds of the Year,' they print returns and rate funds within the categories that they are put in by rating companies like Morningstar and Lipper. Consequently, a fund's classification matters a great deal.
But do firms have any say as to in which categories their own funds should be? Not really, according to Jim Shirley, a research analyst with Lipper. Both Lipper and Morningstar classify funds based primarily on their current and historical holdings. But that is not as straightforward as it sounds. After all, who defines exactly what small-cap' is or what balanced' means? Apparently, the fund trackers do.
"When we first came out with the categories, people were saying, Hey, wait. Don't we get to decide that?'" said Russel Kinnel, director of fund analysis for Morningstar. "Now, I think, they're over that."
Still, while fund companies may not have the last word in terms of classification, they do try to influence it. Firms frequently call Lipper and that the fund tracker is using the wrong classification for a particular fund. Many times, it appears as though the company wants to change the classification simply because the fund will have better numbers against other peers, according to Donald Cassidy, senior analyst at Lipper.
There have even been times when companies will call back a year later and argue an opposite point if it better suits the fund's performance, Cassidy said. "But we keep notes on that stuff," he said.
Changing to Remain Consistent
That's not to say that the trackers ignore the calls they get from fund companies. "Now, we do get some legitimate issues that come up," said Kinnel. "If their discipline just doesn't fit with ours, if their definition of value' is different from ours, there's not a lot we can do. We have to be consistent. However, if a fund has officially changed its strategy, we'll move the classification ahead of time, without necessarily waiting for the three-year average."
Lipper, too, has tried to implement flexibility in its classification system, so that if a board of directors changes the fund's strategy, Lipper may revise its class, even if its model, which includes historical holdings, does not call for it, said Shirley. However, it's important that the portfolio reflect that shift in policy, he said.
There are many times when a fund will end up in between two classifications, said Kinnel. In those cases, Morningstar tries to take in to account the firm's side of the story, he said. "A lot of funds can end up on the borderline, and in that case especially, we pay attention to the fund's stated strategy and what the manager is saying," he said. "We'll look at the market cap discipline and if, historically, they've been strict about it. If the manager buys whatever he wants though, and the fund could be in either category, we'll go strictly with the portfolio," he said.