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In a recent Advisor Perspectivesarticle, Joe Tomlinson reported evidence showing that 401(k) plan sponsors add value in selecting funds, but their risk-adjusted alpha is not enough to beat a comparable index portfolio. Tomlinson then pointed out the need for additional research to help advisors improve upon the fund selection process.

As a step in this direction, I will report on research conducted by my firm and other academics.

A tour through this research provides insight into how to select actively managed equity funds. This research shows a 500-basis point difference in after-the-fact excess returns between the best and worst funds. There are a number of general lessons that advisors can apply to increase their chances of selecting a superior active equity fund.

Fund diamond rating

Our research categorizes the marketplace of active equity mutual funds into peer groups on the basis of investment strategy. We determine each fund’s strategy based on how the fund manager selects and sells stocks in pursuit of excess return.

Within each peer group, we rank funds into five tiers known as fund diamond ratings (DRs). Mutual funds that consistently pursue their strategy and take high-conviction positions within the portfolio garner a diamond rating 5 (DR5), while funds scoring the least among these dimensions earn a diamond dating 1 (DR1).

DRs rely exclusively on the investment decisions of active equity managers, who are placing actual bets with monetary consequences for future performance. We do not employ in-house analysts to refine or second-guess professional mutual fund managers and analysts. Instead, we objectively measure the extent to which a fund manager sticks to a strategy and remains highly convicted.

Mutual fund companies devote significant resources to research equity markets, more than individual investors or most investment professionals can afford. If funds stay true to their stated strategy and invest heavily in their best idea stocks, they have an excellent chance of outperforming their peers. Our research consistently supports this premise.

DRs measure the extent to which managers are truly active in terms of stock selection. A common challenge facing mutual fund investors is avoiding closet index funds. This is a real difficulty — many closet indexers are large, well-known funds that appeal to investors on the basis of brand identity. By paying attention to DRs, though, investors can build portfolios comprised of truly active funds and avoid the costly mistake of investing in return-denigrating closet index funds. Such a mistake could cost the investor hundreds of basis points in return over the long run.

Berk and Green (2004) argued that when fund complexes act rationally, they transform their products into closet funds, as this maximizes firm revenues and profits. DRs measure this life cycle of a typical active equity fund and help investor avoid being swamped by this powerful industry tsunami.

Strategy consistency

After a fund’s strategy, the next most important consideration is how consistently the strategy is pursued over time. We created an objective measure of strategy consistency based on the proportion of stocks held by a manager that correlate to those owned by their strategy peers.

For example, stocks most attractive to valuation managers (one of the peer groups we defined) are referred to as valuation stocks. Similarly, the stocks most attractive to managers pursing the future growth strategy are referred to as future growth stocks. Thus each stock becomes a member of a particular strategy “stock pool,” based on which strategy finds the stock most attractive.

Strategy pool characteristics, such as average market cap and price-to-earnings ratio, change over time as managers within each strategy peer group adjust their holdings. Strategy stock pools are defined by the manager peer groups (strategies) that hold them, not the other way around.

Stock Strategy Pools

Our historical data show that a stock will remain in any given pool for an average of 13 months, with market conditions stocks changing most frequently and valuation stocks being the most stable.

A fund’s strategy consistency measure is based on the percent of stocks from the stock pool that the fund holds. This does not mean that a fund must hold only own strategy stocks in order to be highly rated, but a higher percentage is preferable.