Instead, these funds have actually behave more like their mid-cap style counterparts. Exhibit 4 grades each of these funds relative to their mid-cap style benchmarks, and each fund receives the same or better diversification grades than their Morningstar asset class labels, varying between C- and D+.

Exhibit 4 - Individual fund grades relative to mid-cap benchmarks:

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

Ultimately, the data shows that the labeling of a fund is not an accurate guide to its diversification value in an overall portfolio allocation strategy. If we use these categories to predict behavior, we are at risk of being fooled by faulty labels. For example, returning to Exhibit 4, which grades the funds in the diverse portfolio relative to their best fitting mid-cap counterparts, the data shows that these funds combine to behave like an entirely mid-cap portfolio. Thus, these funds are not behaving like their labels.

If we do not examine diversification relative to the allocation we are attempting to implement for clients and instead choose funds based merely on their label, we run the risk of being fooled. Fundgrades allows you to examine whether funds behave like their labels, and allows you to examine funds in combination to avoid misleading your clients and giving a false appearance of diversification. To avoid constructing portfolios that do not match the targeted asset allocation for a client, we must look beyond labels and to see how funds behave relative to their labeled asset class, and how they behave in combination. After all, as the Nobel Prize winning physicist Richard Feynman states, “For a successful technology, reality must take precedence over public relations, for Nature cannot be fooled.”

Katie Southwick is an intern working for Advisor Perspectives this summer.

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