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Best in Show
by Craig L. Israelsen
University of Missouri-Columbia
From Financial Planning Magazine, February 2002. Reprinted with permission.
Mutual funds compete ferociously for top status in their category.
However, victory is sweet only when enough players join the game and the manager adds value.
hree manager-influenced variables appear to be linked to superior performance (as measured by return): turnover ratio, expense ratio and manager tenure. Less turnover, lower expenses and more experience combine to produce good results. Meaningful comparisons among managed funds, therefore, should measure the manager's input to the fund's performance, not simply the performance of the underlying markets. These three factors really determine which fund is a leader among an appropriately large peer group sample.
Mutual fund comparisons abound, each vying for that coveted "top-of-the-class" status. However, while such comparisons can be useful, they can also be misleading. Fund categories (or sub-categories) are often so narrowly defined that only a few funds remain, making it easy to promote one fund as a leader. For instance, how impressive is it to be the top-rated fund among all aggressive-growth funds with under $200 million in assets that invest in Korean biotechnology stocks?
The first step is to select appropriately large categories that are both large enough and standardized enough to make a fund's leading position meaningful. Morningstar places the domestic-equity mutual funds in its Principia Pro database into one of five different "prospectus-objective" categories: aggressive growth, small company, growth, growth & income and equity-income. The U.S.-equity funds in this analysis have at least five years of performance history (as of Nov. 30, 2001), less than 25% of their portfolio in non-U.S. stocks and less than 10% in bonds. Index funds were excluded. Using these minimal filters, the resulting number of funds, along with some descriptive statistics, are shown in Figure 1.
So, which fund characteristics, particularly those influenced by the fund manager, are associated with equity funds that are the best performers within their class? Several of the characteristics in Figure 1 are clearly influenced by the manager, such as the number of holdings, percentage of assets in the top-10 holdings and turnover ratio. To a lesser extent, the portfolio manager may also influence the annual expense ratio and manager tenure.
Figure 1 shows some interesting linear (or nearly so) trends when examining the mean results across the five fund categories. For instance, standard deviation of return and turnover ratio are highest among aggressive-growth funds and lowest among equity-income funds. Category averages that fall in-between also follow a (fairly) consistent linear trend. Annual expense ratios follow the same pattern except for a slight upturn among equity-income funds. Length of manager tenure displays the opposite quasi-linear pattern, with aggressive-growth funds having the lowest average and equity-income the highest.
Figure 1.
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Aggressive Growth
(n=58)
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Small Company
(n=243)
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Growth
(n=561)
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Growth & Income
(n=242)
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Equity-
Income
(n=68)
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5-yr. annualized return (%)
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6.8
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8.7
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8.9
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8.6
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8.5
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|
Maximum 5-yr. return (%)
|
25.7
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34.5
|
27.9
|
17.5
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16.8
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|
5-yr. standard deviation of
return (%)
|
35.4
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29.7
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25.4
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19.2
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16.6
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Number of
holdings
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108.0
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176.0
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91.0
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114.0
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107.0
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% of assets in
top-10 holdings
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37.5
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27.2
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37.0
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33.4
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31.8
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Turnover
ratio (%)
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135.0
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108.0
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101.0
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73.0
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62.0
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Expense ratio
(annual %)
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1.5
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1.4
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1.2
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1.1
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1.1
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Manager
tenure (yrs.)
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5.0
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5.4
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5.8
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5.6
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5.9
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As evidenced by the data in Figure 1, four of the five groups had very similar average returns for the five-year period ending Nov. 30, 2001. Therefore, the equity market--on average--provided an annualized return of around 8.5% for that five-year period. (The aggressive-growth funds had a somewhat lower average). However, in each category there were funds that significantly outperformed the equity market in general and their own category average in particular (as shown by maximum five-year return). What emerges is a focus on the manager because the manager may have a lot to do with why a fund outperforms or underperforms it's category average.
To find out, the funds in each of the five Morningstar defined categories were ranked by five-year return from highest to lowest and then divided into quartiles based upon five-year return. Averages for each quartile were calculated. Only the results from the first and fourth quartiles will be examined here. The first quartile for each category includes the top 25% funds based upon five-year return. The fourth quartile contains the poorest performing 25% of the group. Figure 2 shows the results for aggressive-growth funds. The average return for the first quartile was 16%, versus -3.4% for the bottom quartile.
Now the detective work begins. Which of the other variables introduced in Figure 1 seem to be associated with a fund that ends up in the top quartile as opposed to the bottom quartile? Funds with superior five-year performance in the aggressive-growth category (Figure 2) have similar volatility (as measured by standard deviation of return) as compared with funds in the bottom quartile. In other words, among aggressive growth funds, standard deviation of return may not be a helpful discriminator between superior and inferior funds. Superior aggressive-growth funds, on the other hand, tend to have a larger number of holdings in the portfolio, a smaller percentage of total fund assets in the largest 10 holdings, lower turnover and expense ratios and a manager with more tenure.
Figure 2.
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Quartiles ranked
by 5-yr. return
n=58
(15 funds per quartile)
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Average for Funds in
1st Quartile
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Average for Funds in
4th Quartile
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Percentage Difference
between 1st and 4th Quartile
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Is The
Difference Important?
(using 25% difference as a
threshold)
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5-yr. annualized return (%)
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16.0
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-3.4
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--
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--
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5-yr. standard deviation
of return (%)
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35.2
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37.4
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6.3
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No
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Number of holdings
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123.0
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88.0
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40.0
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yes
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% of assets in top-10 holdings
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34.1
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43.3
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27.0
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yes
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Turnover ratio (%)
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98.0
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181.0
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84.7
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yes
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Expense ratio (annual %)
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1.2
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1.9
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58.3
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yes
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Manager tenure (yrs.)
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7.5
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3.1
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141.9
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yes
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Figures 3-6 summarize the findings for the other four fund categories. Moreover, in Figures 2-6, the rightmost column indicates whether the difference between the first quartile average and fourth quartile average is important. The determination is based upon the percentage difference between the two, shown in the previous column. A difference of 25% or greater was determined to be an important difference. Between 20% and 25% was viewed as possibly an important difference. (Inasmuch as the quartiles were already ranked according to five-year return, it was not included in the comparison analysis.)
Figure 3.
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Quartiles ranked
by 5-yr. return
n=243
(61 funds per quartile)
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Average for Funds in
1st Quartile
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Average for Funds in
4th Quartile
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Percentage Difference
between 1st and 4th Quartile
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Is The
Difference Important?
(using 25% difference as a
threshold)
|
|
5-yr. annualized return (%)
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15.4
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1.5
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--
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--
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5-yr. standard deviation
of return (%)
|
29.1
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35.1
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20.6
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possibly
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Number of holdings
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137.0
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136.0
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0.7
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No
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% of assets in top-10 holdings
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29.2
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28.1
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3.9
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No
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Turnover ratio (%)
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104.0
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146.0
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40.4
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Yes
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Expense ratio (annual %)
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1.3
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1.6
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22.6
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possibly
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Manager tenure (yrs.)
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6.2
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4.8
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29.2
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Yes
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Figure 4. Growth Funds
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Quartiles ranked
by 5-yr. return
n=561
(140 funds per quartile)
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Average for Funds
in
1st
Quartile
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Average for Funds
in
4th
Quartile
|
Percentage
Difference between 1st and 4th Quartile
|
Is The
Difference Important?
(using 25% difference as a
threshold)
|
|
5-yr. annualized return (%)
|
15.0
|
2.6
|
--
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--
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5-yr. standard deviation
of return (%)
|
27.0
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26.3
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2.9
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No
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Number of holdings
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88.0
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73.0
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20.5
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possibly
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% of assets in top-10 holdings
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38.2
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37.0
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3.2
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No
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Turnover ratio (%)
|
101.0
|
116.0
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14.9
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No
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Expense ratio (annual %)
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1.2
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1.2
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5.1
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No
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Manager tenure (yrs.)
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6.5
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4.3
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51.2
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Yes
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Figure 5. Growth and Income Funds
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Quartiles ranked
by 5-yr. return
n=242
(61 funds per quartile)
|
Average for Funds
in
1st
Quartile
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Average for Funds
in
4th
Quartile
|
Percentage
Difference between 1st and 4th Quartile
|
Is The
Difference Important?
(using 25% difference as a
threshold)
|
|
5-yr. annualized return (%)
|
12.7
|
4.5
|
--
|
--
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|
5-yr. standard deviation
of return (%)
|
19.8
|
18.5
|
7.0
|
No
|
|
Number of holdings
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107.0
|
86.0
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24.4
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possibly
|
|
% of assets in top-10 holdings
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32.9
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35.1
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6.7
|
No
|
|
Turnover ratio (%)
|
84.0
|
87.0
|
3.6
|
No
|
|
Expense ratio (annual %)
|
1.0
|
1.2
|
27.1
|
Nes
|
|
Manager tenure (yrs.)
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6.5
|
4.1
|
58.5
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Nes
|
Figure 6. Equity Income Funds
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Quartiles ranked
by 5-yr. return
n=68
(17 funds per quartile)
|
Average for Funds
in
1st Quartile
|
Average for Funds
in
4th
Quartile
|
Percentage
Difference between 1st and 4th Quartile
|
Is The
Difference Important?
(using 25% difference as a
threshold)
|
|
5-yr. annualized return (%)
|
12.2
|
4.6
|
--
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--
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|
5-yr. standard deviation
of return (%)
|
16.9
|
16.3
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3.9
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no
|
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Number of holdings
|
97.0
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119.0
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22.7
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possibly
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% of assets in top-10 holdings
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32.7
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35.4
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8.3
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no
|
|
Turnover ratio (%)
|
60.0
|
76.0
|
26.7
|
yes
|
|
Expense ratio (annual %)
|
1.0
|
1.26
|
21.2
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possibly
|
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Manager tenure (yrs.)
|
6.6
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5.2
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26.9
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yes
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In Figure 7, the findings are summarized for the five categories:
Figure 7.
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Summary of important differences between 1st
and 4th quartiles by category
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Aggressive
Growth
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Small Company
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Growth
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Growth & Income
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Equity-Income
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|
5-yr. standard deviation
of return (%)
|
no
|
possibly
|
no
|
no
|
no
|
|
Number of
holdings
|
yes
|
no
|
possibly
|
possibly
|
possibly
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|
% of assets in top-10 holdings
|
yes
|
no
|
no
|
no
|
no
|
|
Turnover
ratio (%)
|
yes
|
yes
|
no
|
no
|
yes
|
|
Expense
ratio (annual %)
|
yes
|
possibly
|
no
|
yes
|
possibly
|
|
Manager
tenure (yrs.)
|
yes
|
yes
|
yes
|
yes
|
yes
|
Standard deviation of return: This variable appears to be a poor discriminator between superior and inferior performance. Only among small company funds might a smaller standard deviation of return be related to better performance.
Number of holdings in portfolio: The evidence is lukewarm that more holdings can be associated with superior performance. The exception being among equity income, where funds in the first quartile had fewer holdings.
Percentage of assets in top-10 holdings: The general finding is that this manager-influenced variable is not strongly associated with superior performance. The only exception being among aggressive-growth funds, where the funds in the first quartile had a smaller percentage in the top-10 holdings.
Turnover ratio: In every case, this ratio was lower among funds in the first quartile, and in three of the five categories (aggressive growth, small company, equity-income) it was determined to be an important difference.
Expense ratio: This was always lower among funds in the first quartile, but only convincingly so among aggressive growth and growth & income funds. Weaker correlation was noted among small company and equity-income funds.
Manager tenure: A clear verdict: more time at the helm is a characteristic of funds in the first quartile. More experience is simply better.
Therefore, three manager-influenced variables emerge as being buddy-buddy with superior performance (as measured by return): turnover ratio, expense ratio and manager tenure. So, caution is warranted when you find "best-in-category" comparisons. Be sure to investigate how this fund came to be named "best" in its class. You now have some screens to help answer that question for yourself. Importantly, these screens focus on the human component of fund performance (i.e. the manager(s)) rather than the underlying performance of a particular segment of the equity market. It's worth remembering that it wasn't the general equity market that made Fidelity Magellan such a great fund. It was the manager, Peter Lynch.
Focusing on the management of a fund is good for you and your clients. Too often, a fund is the "best-in-category" because the category is ridiculously small (i.e. boutique funds) or because it benefited by an ephemeral spike in a particular segment of the equity market. A better approach may be to focus on the correlates of superior performance (i.e. low turnover, low expenses, more manager tenure) within broad fund categories.
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Craig L. Israelsen is an associate professor in the department of consumer and family economics at the University of Missouri in Columbia. He can be reached via e-mail at israelsenc@missouri.edu.
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