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Truth in Labeling New Research from FundGrades
By Katie Southwick
July 8, 2008

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If we ignored the fact the fund is not diversified and looked only at performance, one could erroneously conclude that the fund is successful and falsely label this mid cap index fund as a “total market active winner.” In fact, any active fund that merely bought this mid cap index fund would receive the same grades.








Exhibit 1 - Comparison of IJH against a Total Market Domestic Equity Benchmark


Portfolio Grades



Overall

Diversification

Expense

Relative Risk

Return

Risk of Material Underperformance

IJH

Last 3 Years

C-

D+

A+

F

C+

C-

Prior 3 Years

B-

D+

A+

C

B

C+

Last 6 Years

C+

D+

A+

D+

B-

C

However, the diversification grade exposes the inaccuracy of the label “total market active winner.” Over all three time periods, the fund received a D+ for diversification, illustrating this is a poor benchmark for grading this fund. Of course, being a mid cap index fund, you would already know this, but what about the funds you might choose that are not so obviously misclassified?

Let’s contrast investing solely in this mid-cap fund to what, from a labeling perspective, would be an apparently more diversified portfolio of large-cap and small-cap funds, in order to achieve the desired allocation of the total domestic equity market. In Exhibit 2, we select four funds that Morningstar has rated “four stars.” Market cap is weighed at 70% large versus 30% small, so there is a slight bias toward small-cap (relative to a broad-market index), but not enough to materially alter results and styles are equally weighted eliminating any style bias.

Exhibit 2 - Portfolio weights for the “more diversified” portfolio of four star funds based on Morningstar’s asset class labels and the combined portfolio grades as weighted relative to the target allocation of Total Domestic Equities:

Ticker

Description

Selected Asset Class

Weight

MALHX

BlackRock Large Cap Growth Inst

Large Cap Growth

35%

DFUVX

DFA U.S. Large Cap Value III

Large Cap Value

35%

FVFRX

Franklin Small Cap Value R

Small Cap Value

15%

NBMVX

Neuberger Berman SmallCap Gr Adv

Small Cap Growth

15%

Note: DP refers to the “diverse portfolio” as weighted with these specific funds


Diverse Portfolio


Overall

Diversification

Expense

Relative Risk

Return

Risk of Material Under-
performance

DP
Relative to domestic equities

Last 3 Years

C-

C

B-

F

C

C+

Prior 3 Years

C-

D

B-

D+

C

C+

Last 6 Years

C-

D+

B-

D-

C

C+



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