Any suffi ciently complex set of objects may be categorized in a number of different ways, and mutual funds are no exception. Most of the schemes one will encounter, however, classify a fund based on some combination of its stated investment objective, the types of assets it holds, and how it selects those assets. Does the fund pursue capital growth, income, or both? Does it hold stocks, bonds, or both, and in what countries or regions are the issuers of those securities? Does it select stocks based on a qualitative evaluation of the issuing company’s prospects, or on a technical analysis of stock price patterns? Does it hold corporate or government debt securities? The list goes on and on.
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Classifi cation schemes impose a conceptual order upon the otherwise overwhelming mass of detail about individual funds. They also allow for meaningful comparisons among funds. Investors can use them to determine which funds are appropriate for their portfolios (e.g., which funds should be considered for long-term capital appreciation). Ratings organizations can use them to compare funds to indices (e.g., which funds’ performance should be evaluated against the performance of the Wilshire 4500). Fund management companies can use them to measure fund performance against peers (e.g., how well this government long-term bond fund has performed as compared to other government long-term bond funds).
There are enough different mutual fund categorization schemes that we could talk about taxonomies of taxonomies. Instead, we will merely review three of the most commonly used categorization schemes—those formulated by the ICI (the industry’s trade association), Morningstar (a research and rating agency), and Lipper (another research and rating agency). All three schemes (and, indeed, almost all other fund classifi cation schemes) start with the basic breakdown of equity, long-term fi xed income, and money market funds, and extend it to fi ner categorizations. The three schemes differ slightly from one another, refl ecting the different purposes for which they are intended.
The Investment Company Institute
The ICI collects data on mutual fund activity—sales, redemptions, reinvest- ments, net exchanges, and other items—and publishes this data monthly. For the purposes of publishing this summary data, the ICI groups funds into six major investment categories: stock, hybrid, taxable bond, municipal bond, taxable money market, and tax-exempt money market. Within these six broad categories, it recognizes 33 specifi c investment objectives that funds pursue (see Table 4.1).
A scan of the ICI categories reveals that they primarily refl ect what types of securities the funds hold. Within the major asset class breakdowns, funds are further subdivided according to more specifi c security selection criteria (e.g., from a particular geographic region, from a particular industrial sector, issued by a particular state). The ICI’s categorization scheme has changed over time as the number of funds has increased. In 1998, the ICI increased the number of distinct categories it recognized from 21 to 33. In its role as the industry association, the ICI offers no comments or analysis on the perfor- mance of particular funds. It merely collects and publishes data about fund categories for research purposes. The ICI puts a particular fund into a category based on the prospectus description of the fund’s investment objective and policies.
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The Mutual Fund—Product Defi nition 71
Table 4.1 Investment Company Institute Fund Categories and Descriptions Stock Funds
1. Aggressive growth funds invest primarily in common stock of small growth companies with potential for capital appreciation.
2. Emerging-market equity funds invest primarily in equity securities of companies based in less- developed regions of the world.
3. Global equity funds invest primarily in worldwide equity securities, including those of U.S. companies.
4. Growth and income funds attempt to combine long-term capital growth with steady income dividends. These funds pursue this goal by investing primarily in common stocks of established companies with the potential for both growth and good dividends.
5. Growth funds invest primarily in common stocks of well-established companies with the potential for capital appreciation. These funds’ primary aim is to increase the value of their investments (capital gain) rather than generate a fl ow of dividends.
6. Income equity funds seek income by investing primarily in equity securities of companies with good dividends. Capital appreciation is not an objective.
7. International equity funds invest at least two-thirds of their portfolios in equity securities of companies located outside the United States.
8. Regional equity funds invest in equity securities of companies based in specifi c world regions, such as Europe, Latin America, the Pacifi c Region, or individual countries.
9. Sector equity funds seek capital appreciation by investing in companies in related fi elds or specifi c industries, such as fi nancial services, health care, natural resources, technology, or utilities.
Bond Funds
10. Corporate bond–general funds seek a high level of income by investing two-thirds or more of their portfolios in corporate bonds and have no explicit restrictions on average maturity.
11. Corporate bond–intermediate term funds seek a high level of income with two-thirds or more of their portfolios invested at all times in corporate bonds. Their average maturity is fi ve to 10 years.
12. Corporate bond–short term funds seek a high level of current income with two-thirds or more of their portfolios invested at all times in corporate bonds. Their average maturity is one to fi ve years.
13. Global bond–general funds invest in worldwide debt securities and have no stated average maturity or an average maturity of more than fi ve years. Up to 25 percent of their portfolios’
securities (not including cash) may be invested in companies located in the United States.
14. Global bond–short term funds invest in worldwide debt securities and have an average maturity of one to fi ve years. Up to 25 percent of their portfolios’ securities (not including cash) may be invested in companies located in the United States.
15. Government bond–general funds invest at least two-thirds of their portfolios in U.S. government securities and have no stated average maturity.
16. Government bond–intermediate term funds invest at least two-thirds of their portfolios in U.S.
government securities and have an average maturity of fi ve to 10 years.
17. Government bond–short term funds invest at least two-thirds of their portfolios in U.S.
government securities and have an average maturity of one to fi ve years.
18. High-yield funds seek a high level of current income by investing at least two-thirds of their portfolios in lower-rated corporate bonds (Baa or lower by Moody’s and BBB or lower by Standard and Poor’s rating services).
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Table 4.1 (continued)
19. Mortgage-backed funds invest at least two-thirds of their portfolios in pooled mortgage-backed securities.
20. National municipal bond–general funds invest predominantly in municipal bonds and have an average maturity of more than fi ve years or no stated average maturity. The funds’ bonds are usually exempt from federal income tax but may be taxed under state and local laws.
21. National municipal bond–short term funds invest predominantly in municipal bonds and have an average maturity of one to fi ve years. The funds’ bonds are usually exempt from federal income tax but may be taxed under state and local laws.
22. Other world bond funds invest at least two-thirds of their portfolios in a combination of foreign government and corporate debt. Some funds in this category invest primarily in debt securities of emerging markets.
23. State municipal bond–general funds invest primarily in municipal bonds of a single state and have an average maturity of more than fi ve years or no stated average maturity. The funds’ bonds are exempt from federal and state income taxes for residents of that state.
24. State municipal bond–short term funds invest predominantly in municipal bonds of a single state and have an average maturity of one to fi ve years. The funds’ bonds are exempt from federal and state income taxes for residents of that state.
25. Strategic income funds invest in a combination of domestic fi xed-income securities to provide high current income.
Hybrid Funds
26. Asset allocation funds seek high total return by investing in a mix of equities, fi xed-income securities and money market instruments. Unlike Flexible Portfolio funds (defi ned below), these funds are required to strictly maintain a precise weighting in asset classes.
27. Balanced funds invest in a specifi c mix of equity securities and bonds with the three-part objective of conserving principal, providing income, and achieving long-term growth of both principal and income.
28. Flexible portfolio funds seek high total return by investing in common stock, bonds and other debt securities, and money market securities. Portfolios may hold up to 100 percent of any one of these types of securities and may easily change, depending on market conditions.
29. Income mixed funds seek a high level of current income by investing in a variety of income- producing securities, including equities and fi xed-income securities. Capital appreciation is not a primary objective.
Money Market Funds
30. National tax-exempt money market funds seek income not taxed by the federal government by investing in municipal securities with relatively short maturities.
31. State tax-exempt money market funds invest predominantly in short-term municipal obligations of a single state, which are exempt from federal and state income taxes for residents of that state.
32. Taxable money market–government funds invest principally in short-term U.S. Treasury obligations and other short-term fi nancial instruments issued or guaranteed by the U.S. government, its agencies, or instrumentalities.
33. Taxable money market–nongovernment funds invest in a variety of money market instruments, including certifi cates of deposit of large banks, commercial paper and banker’s acceptances.
Source: Investment Company Institute, “A Guide to Mutual Funds,” 2004 (www.ici.org)
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The Mutual Fund—Product Defi nition 73
Morningstar
Established in 1984, Morningstar, Inc., provides investors with informa- tion, analysis, and research, including ratings and other comparative data for mutual funds. Morningstar does evaluate the performance of individual funds, using its fund categories as the basis for comparing funds to their peers. Morn- ingstar used to classify funds according to their stated objectives, but changed in 1996 to base its scheme on what the funds actually hold.10 Research had shown that simply using prospectus language resulted in misclassifi cation of a signifi cant proportion of funds, especially among equity funds.11 Prospectus language allows funds enough latitude that they may “drift” into patterns of holdings that no longer match those described in the prospectus as they pursue higher returns.
Morningstar divides the long-term mutual fund universe into four basic groups: domestic stock funds, international stock funds, taxable fi xed-income funds, and tax-free municipal bond funds. (Morningstar does not categorize or rate money market funds.) Morningstar subdivides these broad categories into 64 specifi c categories for publication of group returns. Table 4.2 lists the 65 Morningstar fund categories as of late 2003. Morningstar aims primarily at the investor as it categorizes funds. “We wanted to group funds that have meaning- ful clusters of characteristics,” a Morningstar spokesman declared. “Investors should be able to identify a group by a label and then be able to pick a fund from that group.”12
Morningstar uses 34 equity fund categories to the ICI’s nine for three reasons. First, it places U.S. general stock funds into nine groups based on the size of companies whose stocks the funds hold, and the fund’s investment phi- losophy (growth, value, or blend). Second, it identifi es 11 categories of sector funds, whereas the ICI lumps them all into one category. Finally, it identifi es 14 categories of international stock funds (based on specifi c regions in which the fund invests or the investment philosophy) to the ICI’s two. The differ- ences between Morningstar and ICI bond categories are smaller, attributable mostly to Morningstar’s recognition of specifi c, single-state, tax-exempt bond fund categories.
Lipper
Lipper Analytical Services started providing fund information in 1973. (Acquired by Reuters in 1998, the fi rm today simply calls itself Lipper.) Whereas Morn- ingstar aims primarily at investors and fi nancial advisors, Lipper earns the bulk of its revenues from the fund companies. Many management companies base at least part of their portfolio managers’ compensation on how well their funds do as compared to their counterparts within the Lipper categories.
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Combining Risk and Return: The Morningstar Stars
Americans like for critics to sum up their critiques with simple measures of overall goodness.
Thus movie reviewers give one or two thumbs up; Michelin tells us where the fi ve-star restaurants are; Consumer Reports summarizes its product analyses with patterns in little circles. We see this refl ected even in business-to-business communications, as when Moody’s and Standard and Poor’s conduct exhaustive analyses of companies, and then Table 4.2 Morningstar Fund Categories
Domestic Equity International Equity Taxable Bond
Large Growth Mid-Cap Growth Small Growth Large Blend Mid-Cap Blend Small Blend Large Value Mid-Cap Value Small Value Specialty-Natural Res Specialty-Technology Specialty-Utilities Specialty-Health Specialty-Financial Specialty-Real Estate Specialty-Communications Bear-Market
Conservative Allocation Moderate Allocation Convertibles
Specialty-Precious Metals World Stock
Europe Stock Diversifi ed Pacifi c/Asia Pacifi c/Asia ex-Japan Stk Japan Stock
Diversifi ed Emerging Mkts Latin America Stock World Allocation Foreign Large Value Foreign Large Blend Foreign Large Growth Foreign Small/Mid Value Foreign Small/Mid Growth
Long Government Intermediate Government Short Government Long-Term Bond Intermediate-Term Bond Short-Term Bond Ultrashort Bond Bank Loan High-Yield Bond Mulitsector Bond World Bond
Emerging Markets Bond Stable Value
Municipal Bond High-Yield Muni Muni National Long Muni National Interm Muni National Short Muni Single State Long Muni Single State Int/Sh Muni New York Long Muni New York Int/Sh Muni California Long Muni California Int/Sh Muni Florida Muni Pennsylvania Muni Massachusetts Muni New Jersey Muni Ohio Muni Minnesota Muni Single State Short Source: Reprinted by permission of Morningstar, Inc.
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The Mutual Fund—Product Defi nition 75
summarize them with short letter/number ratings. And ratings can carry great weight—
fi ve stars from Michelin or an AAA rating from Moody’s has large fi nancial ramifi cations for the organization that receives it.
Morningstar, Inc. has achieved a similar effect with its star ratings for mutual funds.
Many investors use this popular fund rating scheme as a navigation beacon marking the channel to good fund investment. One study in 1996 found that 90 percent of the new money that fl owed into equity mutual funds in 1995 went to funds with four- or fi ve- star ratings from Morningstar.14 In 1997, SmartMoney named Morningstar’s president Don Phillips as the fourth most infl uential individual in the industry (after Michael Price, Jack Bogle, and Ned Johnson). “It’s no wonder fund companies get so worked up over Morningstar ratings,” SmartMoney commented. “If a fund can get four or fi ve stars ... it’s almost assured a big rush of cash. In the fi ve months since Invesco started advertising the fi ve stars earned by Strategic Financial Services, its assets have grown by 37 percent.” 15
In 2002, Morningstar revamped their fund rating process—the ubiquitous star rating —in order to make it less sensitive to market movements, and more refl ective of the fact that investors were far more sophisticated than they were when the star rating was introduced in 1985. The original star rating compared funds within extremely broad peer groups. Domestic-stock funds of every stripe were compared with other domestic stock funds, for example, while all taxable bond funds were lumped together. That had an unfortunate side effect: When a particular style of investing was hot—like growth was in the late 1990s—a disproportionate share of funds within that style received four or fi ve stars. It didn’t matter if the manager was good or bad.
Morningstar’s category rating, launched in 1996, assesses funds’ risk/reward profi les alongside other offerings that practice a similar style. Because it helped investors separate managers who were truly skilled within their peer groups, the category rating quickly became a favorite of the Morningstar analysts and others.
The new star rating takes part of the old star rating (its emphasis on long-term performance) and part of the category rating (its emphasis on apples-to-apples comparisons) and merges them into a single rating. Rather than using four broad peer groups to rate funds (domestic stock, international stock, taxable bond, and municipal bond), as they did in the past, Morningstar’s new rating compares funds with others in one of the 64 different Morningstar categories.
Aside from the switch to category-based peer groups, the basic framework for the original star-rating methodology remains intact. As in the past, the new rating provides a snapshot of a fund’s historical risk/reward profi le. It rates funds on a scale of one to fi ve stars, and takes sales charges into account. Funds with less than a three-year track record are not rated.16
The Morningstar stars have become so widely accepted at least in part because they indicate the historical risk-adjusted performance of a fund in a straightforward, easily understood way. The consuming public has clearly embraced the star rating, much as it has the Michelin restaurant ratings.
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Because funds use the categories as a basis for compensation, Lipper employs a relatively large number of narrowly defi ned categories—84 in all.
In 1999, Lipper revised its categories for U.S. stock funds, in recognition that its old approach (based on prospectus language) was not suffi ciently precise.
Similar to Morningstar, Lipper changed to categories that refl ect what the funds actually do. This caused a furor in some parts of the industry, since it resulted in a number of funds being reclassifi ed, potentially affecting how funds stack up against rivals, and, therefore, how managers are compensated.13 Table 4.3 shows the Lipper categories as of early 2005.
Table 4.3 Lipper Open-End Fund Classifi cations
U.S. Diversifi ed Equity Funds Mixed Equity Funds Open-end Fund and Variable Insurance Product
Classifi cations
1. Growth Funds (Large, Multi, Mid, and Small Cap) 2. Core Funds (Large, Multi, Mid, and Small Cap) 3. Value Funds (Large, Multi, Mid, and Small Cap) 4. Equity Income Funds
5. S&P 500 Index Funds
6. Specialty Diversifi ed Equity Funds
28. Balanced Funds
29. Balanced Target Maturity Funds 30. Convertible Securities Funds 31. Flexible Portfolio Funds 32. Global Flexible Portfolio Funds 33. Income Funds
34. Ultra Short Obligation Funds
Sector Equity Funds
Short/Intermediate-Term U.S.
Treasury and Government Funds 7. Environmental Funds
8. Financial Services Funds 9. Health/Biotechnology
10. Natural Resources Funds Real Estate Funds 11. Science & Technology
12. Specialty & Miscellaneous 13. Utility Funds
14. Telecommunication Funds
35. Intermediate U.S. Treasury Funds 36. Intermediate U.S. Government Funds 37. Short-Intermediate U.S. Government Funds 38. Short U.S. Government Funds
39. Short U.S. Treasury Funds
World Equity Funds
Short/Intermediate-Term Corporate Fixed-Income Funds
15. Canadian Funds 16. China Region Funds 17. Emerging Markets Funds 18. European Region Funds 19. Global Funds 20. Global Small-Cap Funds 21. Gold-Oriented Funds 22. International Funds 23. International Small-Cap Funds 24. Japanese Funds
25. Latin American Funds 26. Pacifi c ex Japan Funds 27. Pacifi c Region Funds
40. Intermediate Investment-Grade Debt Funds 41. Short Investment-Grade Debt Funds 42. Short-Intermediate Investment-Grade Debt
Funds
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