Thursday, February 05, 2009

Mutual Fund Family Performance

Many publications provide periodic data or rankings on composite mutual fund family performance. A question arises as to whether investment fiduciaries should derive comfort or concern from these lists.

For instance, in a recent WSJ article, the performance of the 10 largest mutual fund families was profiled. The fund family rankings were based on asset weighted excess returns over their morningstar style box from the market peak in October 2007. The article acknowleges that "this overall scoring may have little correlation to your personal investment results" though they point out that "the results give some indication of how each complex has served its investors overall since the market peak".

The provides its own ranking of fund families based on its rating system which they indicate should "provide a solid framework for making informed, timely investment decisions".

There is often dissonance between lists. For instance, The Street's top performing fund family with more than 100 rated funds rates a 2.6 under the Morningstar ranking system where "the scores range from 1.0 to 5.0. A score below 2.5 is an indication that the firm has met with little success in that asset class. A score between 2.5 and 3.5 indicates the firm is about average".

All performance rankings have limitations, especially those based on short time periods. Family fund rankings have even less value since they dont reflect the characteristics of any specific investment strategy. They are simply an artifact of a set of asset class, investing process, research and outlook biases that may be correlated across funds in a family.

Investment fiduciaries whose investment programs, such as 401(k)'s, hold many investments from a single fund family may not be fully meeting their fiduciary responsibility to diversify plan assets. A study by Elton, Green and Gruber, "The Impact of Mutual Fund Family Membership on Investment Risk" finds:
"evidence that mutual fund returns are more closely correlated within than between fund families. As a result, restricting investment to one fund family leads to a greater total portfolio risk than diversifying across fund families. The increased correlation is due primarily to common stock holdings, but is also more generally related to families having similar exposures to economic sectors or industries. Fund families also show a propensity to focus on high risk or low risk strategies, which leads to a greater dispersion of risk across restricted investors. An investor considering adding an additional fund either inside or outside the family would need to believe the inside fund offered an additional 50 to 70 basis points in return to achieve the same Sharpe ratio."
Using fund family ranking information to assess the merits of an investment progam would be like selecting a job candidate by interviewing her family. Though some general traits may be "genetic", investment performance and therefore fiduciary attention should correlate to the unique characteristics of each investment fund.

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