Which Mutual Fund Style Index Is for You?

In the U.S., investment research firms have developed a host of domestic style indexes for investors to more accurately assess the performance of their U.S. equity mutual funds. Investment research firms construct the style indexes by assigning all of the publicly traded companies domiciled in the U.S. into specific style categories based on their identified investment style characteristics and market capitalization. By organizing companies in this manner, it is possible to construct a host of meaningful benchmark proxies that can be used by investors in order to more accurately evaluate the performance of their mutual funds.

As one can imagine, the organization of publicly traded companies by investment style and market capitalization is a complex undertaking. Therefore, it is important for investors to have an understanding of the criteria used to construct the style indexes before using them to make any performance assessments of their mutual funds. Here's how two of the most well-known investment research firms construct their benchmarks, and a five-step process to help ensure that you are making an accurate performance assessment.

There are three types of equity mutual fund style categories. The first style category is referred to as value because it represents a style orientation of companies that are trading at a discount in relation to their anticipated intrinsic value. Value companies are typically found in depressed industries and in industries that are out-of-favor, and typically exhibit a low price-to-earnings ratio and a low price-to-book value ratio.

The second style category is growth, and it typically consists of companies that are expected to have high future earnings growth. Companies assigned to the growth category usually trade at a premium and typically exhibit a high price-to-earnings ratio, a high price-to-book-value ratio and a high price-to-sales ratio.

The third style category is core, and it's made up of companies that have a blend of both value and growth characteristics. (See also: Financial Ratio Tutorial.)

Two of the most widely known investment research firms are Russell Investments and MSCI Barra. Russell Investments began creating benchmark indexes in 1984 in order for investors to have more valid benchmark proxies. In the global arena, MSCI Barra has been constructing equity indexes for more than 25 years, and recently developed a host of U.S. equity style indexes in order to foster investment performance evaluation.

For the purposes of constructing style indexes, both Russell and MSCI Barra have developed comprehensive guidelines for defining eligible corporate securities and membership by market capitalization and determining investment style. Based on the criteria listed in the table below, Russell and MSCI Barra assign more than 8,700 publicly traded U.S. companies to style categories in order to build benchmark proxies. Once these benchmarks are constructed, they are used by investors to gauge the performance of their investment options.

As you can see from the table above, Russell and MSCI Barra use different factors to define investment style. As a result, both absolute index performance and index performance by specific style category will most likely differ during some measurement periods. These discrepancies make it difficult for investors to determine the amount of alpha generated by the portfolio manager. Given this discrepancy, one could make the case that active management has, or has not, added much value for the period, depending on the selected benchmark proxy used to assess the mutual fund's performance. (See also: Index Investing Tutorial.)

Moreover, at the macro level, general themes about the performance of style categories may be affected by the factors used to construct the style indexes, because in some cases an index provider may show value outperforming growth, whereas another provider may show growth outperforming value. This is a significant problem for investors, because it puts them in a compromised position in terms of making a performance assessment, and determining whether they need to make a change with regard to the mutual funds they are using.

To help investors properly use investment style indexes to make an assessment about the performance of their investment options, we recommend that investors follow a five-step process.

1. Review the mutual fund prospectus. By doing so, you can understand the investment manager's investment methodology, style orientation and market capitalization range.
2. Examine the characteristics of the mutual fund. Ensure that it is structured in a manner that is true to the style category and market capitalization specified by the investment manager.
3. Review the makeup of the manager-specified benchmark. Ensure that it is constructed in a manner that facilitates a fair and accurate performance comparison.
4. Assess the relative performance of the investment option against the investment manager's specified benchmark proxy.
5. Compare the performance of the fund against a similar benchmark proxy established by an independent investment research firm. This will allow you to reassess the relative performance of the fund.

After these steps have been taken, investors should be in a much better position to properly assess the performance of their mutual fund and be in a better position to determine if any changes need to be made. (See also: Don't Forget to Read the Prospectus!)

Style analysis can be a very useful tool for selecting equity mutual funds, choosing the appropriate benchmark proxy and making an investment performance assessment. However, the manner in which style is defined and measured by investment research firms must be understood before investors can draw any conclusions about the relative performance of their investment options.