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

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We would expect the diverse portfolio to be less risky and more diversified than the mid cap index fund in Exhibit 1 when compared to our total domestic market benchmark. Yet, for the last three, prior three and six year periods, we see the relative risk of this seemingly “more diversified” portfolio being the same or higher than the mid cap index fund relative to the targeted total domestic equity benchmark. (Mind you, we were attempting to assemble a more diversified portfolio of funds that includes all market caps and styles in similar proportion to the domestic equity market.) To make matters even worse, the additional risk this combination of funds produces has a lower return grade in ALL time periods relative to the mid cap index fund. More risk and less return; was that what we were attempting to accomplish by diversifying?

The diversification grades in Exhibit 2 for our supposedly consciously diversified portfolio (based on labels) exposes that the portfolio as combined is not materially more diversified than a portfolio comprised of a just mid cap index fund (Exhibit 1). Diversification grades for both our supposedly diversified portfolio and the mid cap index fund range from D to C relative to the allocation target of total domestic equities. Over the last six years, both the diversified portfolio and mid cap index fund graded D+ for diversification, meaning both are equally bad fits for a target of total domestic equities.

So, neither the “diverse” portfolio as constructed nor the mid-cap index fund behave like the diversified domestic equity portfolio that we hoped to create. Although the mid-cap fund had higher return grades, we know that this fund is not good choice for our allocation target because it is not diversified and is making a big bet against our allocation target. But, the diverse portfolio is also not a good choice because it is not really materially more diversified than the mid-cap fund. Why is this the case? The components of the diverse portfolio do not have high correlations to their respective labels and in fact behave more similarly to their mid cap counter parts.

In Exhibit 3, we see how fundgrades.com grades the funds in the diverse portfolio relative to their Morningstar labels. All of these funds receive below average grades in diversification. In fact, three of the four funds have a diversification grade that is either the same or worse than that of the mid-cap index fund, relative to total domestic equities. Thus, although combining these funds based on their label might appear to build a diverse portfolio, they are not behaving like their labels and the portfolio will be no more diversified.

Exhibit 3 - Individual fund grades relative to their “label”

Note: The following grades are based on the last three years of data




Ticker

Description

Asset Class

Overall

Diversity

Expense

Relative Risk

Return

Risk of Material Underperformance

MALHX

BlackRock Large Cap Growth Inst

Large Cap Growth

D+

D

C+

F

C+

C+

DFUVX

DFA U.S. Large Cap Value III

Large Cap Value

C-

D

A+

F

C

C+

FVFRX

Franklin Small Cap Value R

Small Cap Value

C

C-

C-

B-



NBMVX

Neuberger Berman SmallCap Gr Adv

Small Cap Growth

C

D+

C

C

B-

B



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