Will Fund Classification Hurt Your Fund Selection?

by: CFA Institute Contributors

by A. Michael Lipper, CFA

Introduction

I have crossed the street to focus on fund and manager selection. In my former role at Lipper Analytical, now Lipper, Inc., a Thomson Reuters affiliate, I wanted to contribute something of benefit for the various fund groups and their directors as subscribers. This was accomplished by creating smaller competitive leagues and subdividing the list by increasingly narrow fund objectives, using total net asset groupings, and measuring performance in five different time periods per weekly report. Over time there were multiple opportunities to be highly ranked.

As a selector, on the other hand, I search for a fund or funds that fit a specific need in terms of a combination of portfolio, expense and management skills both at the portfolio and business levels. Absolute performance is critical for some accounts. In other cases, relative performance is very important. My concern is that most benchmarks, be they securities or fund indices, are not structured to meet the real needs of the accounts for which I have responsibility. Part of the problem is that the labels attached to various measuring sticks are not descriptive enough.

Small Caps

Many small cap funds are benchmarked against the S&P 600 Index. Institutional "gate keepers" or first level filters mistakenly believe the 600 represents a pure play measure of American small cap companies. They are correct that all 600 have their legal domicile in the United States and/or have their main market in the U.S. According to McGraw-Hill Financial's survey of the components of their S&P 600 Index, in 2012 these companies have identified that 38.97% of their revenues were generated overseas and perhaps more revealing, 33.2% of their taxes were paid overseas. Clearly there was a great deal of variety as to these small companies' foreign involvement. In examining the roster I found twenty-three companies that had over 50% of their sales from overseas sources. As a matter of fact, I found four which had foreign sales of over 75%. Since for many years sales outside of the U.S. have been (in local currency terms) growing faster than in the U.S., I am willing to bet that a number of funds that are characterized as domestic small caps are in reality global or possibly international small caps either now or will be in future statement statistics.

The near-term future

Small cap funds may be particularly interesting now. The higher-quality small cap funds had a relatively good third-quarter performance (see many of the Royce* funds). I am guessing that the underlying quality companies had significant foreign sales. This is particularly important given that the Financial Times reported this past Sunday that there is evidence that the global economy is coming back, led by the richer countries. For the moment, the classification of small cap appears to be working. Nevertheless, from a selector's viewpoint it is a flawed classification.

Better Classifications

Originally, funds were slotted into classifications solely on what the funds' marketing people claimed they were. Over time, this yielded to the language in the prospectus created by the firms' lawyers. Their descriptions became so broad that they could do almost anything permissible under the law. We then started to use fundamental standards for earnings growth, price-to-book value, yield, market capitalizations, and other measures. The data sources for these were the unadjusted financial statement statistics.

Because both the fund business has grown and the complexities of the markets have expanded, more useful classifications are needed. I have already pointed out that higher-quality small-cap funds started to produce better performance in the third quarter after lagging for more than a year. This is clearly an example where one or more measures of quality will help selectors. Other such measures might have to do with the difference between turnover in dollars versus turnover in names, operating margins adjusted for net interest, trading liquidity measured against free float, and others. Some of these measures would be particularly useful in comparing companies with different accounting systems in different countries.

The bottom line is this: Pure performance ranking numbers in one period are not an important selection device today.

Disclaimer: Please note that the content of this site should not be construed as investment advice, nor do the opinions expressed necessarily reflect the views of CFA Institute.