We have written previously about FundGrades.com, a free research tool that grades funds with an overall combined grade based on diversification, expense, relative risk, return and underperformance risk. This article is based on a recent paper by Dave Loeper, CEO of Financeware, Inc., the provider of www.fundgrades.com, showing new ways advisors can utilize this system.

When creating a portfolio to optimize asset allocation, how important is a fund’s label?

Using research from FundGrades.com, advisors can determine whether the labeling of a fund is an accurate guide to its diversification value in an overall portfolio allocation strategy. To be confident the target asset allocation is achieved, advisors must examine both how funds behave and how diversified they are both individually and when combined into a portfolio.

For example, a seemingly diverse portfolio consisting of funds designed to match a broad-market index based on their asset class labels, may unwittingly behave like one composed entirely of mid-cap funds if behavior and diversification are ignored. Thus, when creating a portfolio, we must look beyond just the labels and pay attention to how funds behave as a combined portfolio relative to the asset classes and weights selected in the overall allocation strategy.

Advisors should pay attention to diversification, in addition to examining relative risk and return. If we focus only on risk, return and the asset class labels, it is easy to misinterpret the behavior of any portfolio, and thus be fooled. One might overestimate performance and conclude that a fund behaves more favorably than it actually does. To truly measure a fund’s behavior in an allocation strategy, we also must look at its diversification grade. As an example, Exhibit 1 grades the performance of the iShares S&P Mid Cap 400 (IJH) fund over the past six years and shows that the fund receives above average return grades relative to an obviously erroneous benchmark of total domestic equities. (Fundgrades permits the user to select any of 31 benchmarks against which to grade any fund.) Three years ago, the fund received a B for return and a C relative risk (see the row Prior 3 Years in Exhibit 1), implying relative performance alpha.

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