Mutual Funds

Mutual funds are publicly traded regulated investment companies. A mutual fund is a firm pooling and managing the funds of its investors. Mutual funds can be classified in several ways: open or closed end, load or non-load, diversified or non-diversified, and actively-managed or indexed. Some index funds are exchange-traded (ETFs).

An open-end mutual fund issues or redeems its own shares at their net asset value (NAV). The shares of a closed-end fund are traded through brokers at market prices like a common stock; the fund will not redeem shares at their net asset value, and the market price of the fund can differ from the net asset value.

A 100% no-load mutual fund charges annual operating expenses but no sales commissions or similar fees. A load fund charges annual operating expenses, a front-end or back-end sales commission, or interim charges known as 12b-1 fees.

A diversified fund has limits on the concentration of its stocks in single companies, industry groups, and economic sectors. A non-diversified fund can be concentrated in a few companies in one industry group or economic sector. Diversified funds typically have prices that are more stable than those of non-diversified funds.

A so-called actively managed fund has an investment manager or team that picks the stocks. An index fund is passively managed and merely tracks an index. Index funds typically have lower expenses, lower turnover, higher tax efficiency, and are fully invested. Broad index funds more consistently year after year have returns higher than most actively managed funds.

 

Epidemiology of a Contagion

How do pricing effects become established? Here is one possible scenario. First, highly-regarded academic peer-reviewed journals in finance and financial economics publish articles on the size effect (market capitalization) and value effect (market price-to-book value ratio) in financial asset pricing. Size (market capitalization) is inversely related to return, so small-capitalization stocks have higher average risk-adjusted returns than large-capitalization stocks. Book value-to-market value ratio (style) is positively related to return, so high book-to-market value stocks (value style) have higher average risk-adjusted returns than low book-to-market value stocks (growth style).

Second, the financial gurus and stock market pundits explain the scholarly research findings to Wall Street and the finance industry who develop new mutual funds and other products to exploit these supposed anomalies of mispricing in the stock market. If anyone asks the fund managers about the validity of these new-found stock pricing effects, the relevant academic journal articles are cited.

Third, the indexers create new market indices to track the performance of funds designed for different sizes of companies (small cap, mid cap, and large cap as measured by market capitalization) or for different investment styles (value and growth companies as measured by their book-to-market value ratio).

Fourth, deadline journalists in the financial press fill their columns with articles about the differential success among different sizes and different styles, and quote leading academicians as authoritative experts about whether small size and growth style are currently in or out of fashion, thereby subtly shifting the emphasis from size and style to market timing shifts among the categories of size and style.

Academic gurus, financial pundits, investment managers, fund marketers, and deadline journalists may superficially seem to serve investors. Academia, Wall Street, and Deadline Journalism (academic publishing industry, finance industry, and media industry) gain from these alleged pricing effects, but individual investors lose because the effects are not valid — rather, they are logically circular pricing fallacies. Since their first publication in early 1980's, millions of persons to invest billions of their savings at current market prices in funds opportunistically named or renamed to included the words small or growth to exploit the size and style fallacies, resulting in a massive misallocation of capital in the economy and transfer of wealth among risk-bearing securities.

It may be just a matter of time before an article is published in an academic peer-reviewed journal about newly discovered anomalous risk-adjusted financial asset pricing due to a geographical effect, i.e., domestic, foreign, overseas, international, or emerging markets. One argument may be that the world's national economies are sufficiently independent of one another, notwithstanding significant and increasing international trade and globalization, that their expansion and contraction phases are out of synchrony enough to provide a type of hedge against one another. This may be aided and abetted by the argument that the emerging markets have relatively inefficient pricing mechanisms because they are new, small and undeveloped, thereby offering the astute fund manager easy pickings. Such notions are a substitute for thinking.

 

Deadline Journalism

Walter Lippmann, in his classic book entitled Public Opinion, 1922, said: "For the most part we do not first see, and then define, we define first and then see. In the great blooming, buzzing confusion of the outer world we pick out what our culture has already defined for us, and we tend to perceive that which we have picked out in the form stereotyped for us by our culture." This explanation of how the press thinks helps to demystify the press. The pressure of deadlines prohibits any serious reflection. The important question is, Where does the press get the stereotypes that shape its coverage.

In the Getting Going column in The Wall Street Journal on page C1 dated 20 June 2000, an article entitled "Don't Use Index Funds as Sector Bets", Jonathan Clements writes:

"Not surprisingly, indexers pay a lot of attention to what academics say. In particular, indexers have been influenced by two pieces of research. First, there was the 1981 Journal of Financial Economics paper by Rolf Banz, who pointed out that small stocks outperformed large stocks. That was followed by a June 1992 Journal of Finance paper by Eugene Fama and Kenneth French, which detailed superior performance by value stocks.

"This research has prodded many investment advisers to overweight small companies and value stocks, in the hope of earning market-beating returns. But unlike the academics, many of these advisers argue that this is actually a less risky strategy."

For a closer look at the size and value effects, read the abstract of the paper entitled "Critique of Asset Pricing Circularity."

 

Fund Classification

Mutual funds are frequently classified by investment objectives based on size, style, and geography. The definitions of size (small, medium, and large, as measured by market capitalization) and style (value and growth, as measured by book value-to-market value ratio or its inverse) are simplistic at best and misleading at worst. Moreover, size and value are logically circular explanations of total return which includes both price appreciation and dividends. Therefore, any size or style of stock can be expected to return over time and across stocks as much or as little as any other size or style.

The size, value, and geographical categorizations of stocks arbitrarily reduces the universe of stocks for investment. A smaller stock universe means fewer investment opportunities. Starting with the largest practicable universe of stocks, an investor should apply only meaningful screens to either include or exclude stocks meeting criteria of interest. If long-term total return is the goal, it makes sense to apply, for example, socially responsible investing criteria to serve personal values, or minimum share price and average daily trading volume criteria to avoid manipulative situations. But for the same goal, it doesn't make sense to apply size, value, or geographical criteria for screening stocks.

The major mutual funds families, mutual fund reviewers, and indexers most commonly use size, style, and geography to categorize funds and indexes. Practical fund categories include country of domicile where regulated and currency of record. Useful company categories include size as measured by annual sales revenue, growth as measured by three-year free compound increase in cash flow to common equity per fully-diluted share, and geography as measured by percentage of sales revenue originated in home country. Check out the better known mutual fund performance ranking services below.

CDA/Wiesenberger (Thomson Financial Services) — Fund • prospectus investment objective (unrelated categories including small cap, mid cap, large cap S&P 500, growth, domestic, non-US, global, emerging markets, sectors and specialties).

Lipper Indices (a Reuters Company) — Fund • market capitalization (large-cap, multiple-cap, mid-cap, and small-cap), • style (growth, core, and value): significantly higher expected long-term earnings growth with above average price-to-earnings ratio, price-to-book value ratio, and 3-year earnings growth rate (growth); wide latitude with average price-to-earnings ratio, price-to-book value ratio, and 3-year earnings growth rate (core); and long-term capital gains from companies undervalued based on price-to-current earnings, book value, asset value, or other factors with below average price-to-earnings ratio, price-to-book value ratio, and 3-year earnings growth rate (value), • geographical region (international and emerging markets), and • specialties.

Lipper investment/fund classification definitions are similar for the indices except that the indices only include the 30 largest funds within the investment objective or fund category. In some cases the index may only be comprised of 10 funds if the category does not have 35 portfolios. The fund category definitions can be applied to indices.

The Lipper Indices are equally weighted indices of the largest mutual funds within their respective investment objective, adjusted for the reinvestment of capital gains and income dividends. For the complete description of each investment objective, see the Lipper DEFINITIONS. The following example can be used as a guide:

Lipper Small Company Index
The Lipper Small Cap Fund Index is an equally weighted index of the largest mutual funds within the Small Company Growth investment objective, as defined by Lipper. The index is adjusted for the reinvestment of capital gains and income dividends.

Lipper's Portfolio Evaluation Group assigns objectives/fund classifications.  Fund classifications are based upon portfolio holdings, and investment objectives are based upon prospectus investment objective language.

According to Lipper, portfolio-based classification and comparison of funds is the best practice in determining the most insightful performance rankings and most precise categorization. This is because these peer comparisons are based upon the characteristics of the specific stocks in the underlying funds, rather than upon a broader investment objective stated in a prospectus. Prospectus-based classification is less reliable because prospectus investment objectives are marketing language and not binding commitments.

Morningstar: Funds — Fund • market capitalization (small, medium, and large), • price-to-book value ratio (value, blend, and growth), • geographical region (domestic and international), and • specialties.

Also check out some of the categories of the two largest mutual fund families and a leading indexer below:

Fidelity Funds — Fund • market capitalization (small cap, mid cap, and large cap), • price-to-book value ratio (value and growth), • geographical region (international, overseas, world regions and countries), and • sectors and specialties.

Vanguard Funds — Fund • market capitalization (small cap, mid cap, and large cap), • price-to-book value ratio (value and growth), • geographical region (international, world regions and countries), and • sectors and specialties;
Vanguard Index Trust Growth Portfolio and Value Portfolios are based on S&P/BARRA Value and Growth Indexes which in turn are based on price-to-book ratio.

Frank Russell Company — U.S. Equity Indexes: Style Indexes: Russell 1000 Growth Index and Russell 1000 Value Index are based on market capitalization, price-to-book value ratio, and forecasted growth value.

We suggest another way of classifying funds and evaluating the performance of both the funds and their managers:

Global Stock Valuation — Manager • personal profile (character, energy, originality, intelligence) • incentive rewards, • tenure in present position, • bull market performance, • bear market performance, • source of ideas, • stock selection criteria; — Fund • universe of stocks, • investment objective, • investment strategy, • selection criteria, • percent invested (non-cash), • portfolio turnover, • tax efficiency, and • selling and management fees.

Fund Performance

Fund classification is the first implicit step in fund performance evaluation. Often performance is measured against a benchmark such as a market index and against other funds in the same category, often a peer group index. Any mutual fund can be shown to have better or worse performance depending on three choices: first, the holding period; second, the metric of performance; and third, the benchmark if relative performance is measured. Performance measurement based on comparison to an benchmark that is erratic can say more about the benchmark than the mutual fund. For additional information about fund performance evaluation, see indices.