CHICAGO - Equity mutual funds are trying to more closely match particular investment objectives, in hopes of attracting more 401(k) plan assets and becoming user-friendly to investment management consultants.
"Many families are opting for straightforward, tightly defined funds that are designed to track benchmarks, fit neatly into portfolios and consistently meet customer expectations," wrote John Rekenthaler, publisher of Morningstar Inc., a Chicago mutual fund research firm, in a report that looked at the 20 largest fund families.
The report showed the largest fund families vary widely in the degree to which their diversified equity funds conform to stated investment objectives. In fact, some fund families view it as a virtue to succeed by being different from the norm.
Indeed, Morningstar's analysis found conformity is by no means the key to success.
Putnam Investments, Boston, which had the highest R-squared among the top 10 fund families, also happened to have the highest total returns during the trailing three-year period studied.
AIM Advisors Inc., Houston, the 11th largest fund family and which also has a high R-squared, was a close runner up.
But both Fidelity Investments, Boston, and Janus Capital Corp., Denver, whose funds often stray from the norm, also posted above-average returns. So has Twentieth Century Mutual Funds, Kansas City, Mo., which "is only a moderate conformist," the report said.
Morningstar measured how closely each diversified U.S. equity fund "fit" its objective. It did so by running a regression of its trailing 36 months' returns against its objectives. It then used the result to calculate the fund's R-squared measure. Funds with higher measures tend to move in tandem with the overall objective, while those with low measures don't much resemble competitors within their objective category.
R-squared is the percentage of a portfolio's total return explained by the market risk level. In the case of this study, the "market" refers to the objective category.
Among the 20 largest families, Van Kampen American Capital Management Inc., Oakbrook Terrace, Ill., had the highest R-squared, at 90.7. Janus Funds had the lowest, at 68.9.
Among the 10 largest families, Putnam had the most tightly defined funds, with an R-squared of 88.5; Merrill Lynch & Co., New York, had the least predictable funds, with an R-squared of 72.8.
The average R-squared for each of the fund families was construed by Morningstar to summarize that family's willingness and ability to construct funds that fit investor expectations.
Putnam has what Morningstar terms internal "style police" whose job it is to prevent funds from straying from their objectives. Other fund families are more opportunistic. For instance, "Janus is famous for moving its cash into and out of the market, a trait that fails to endear it to investors who want to control their own asset allocation," Mr. Rekenthaler wrote.
In response, Mark Whiston, Janus' chief marketing officer, said: "We have historically used cash as a residual of our buy and sell decision. If (good stocks) are not there, we don't buy."
In his report, Mr. Rekenthaler also said: "Merrill Lynch has also been known to set its own definitions." In fact, Morningstar reclassified the Merrill Lynch Capital fund as a balanced fund instead of a growth and income fund against Merrill's wishes because the fund routinely holds up to half its assets in bonds.
Gregory Upah, first vice president of Merrill Lynch Asset Management, Princeton, N.J., said the key issue for investors is that funds stick to their prospectus guidelines, not the pattern of investment followed by peers in their objective group.
"Some of the best funds out there have a high degree of latitude. We think that's fine as long as you communicate it to investors," Mr. Upah said.
Mr. Whiston agreed, noting Janus' stock fund prospectuses have broad-based investment parameters.
Both Janus and Merrill have been successful marketing to defined contribution plans despite their relatively low R-squared statistics from Morningstar. "We haven't had any problem. We were never excluded from a search or questioned about the ability of funds to maintain the (strategy) described in the prospectus," said Mr. Whiston.
Mr. Whiston said conforming to objectives such as small- or large-cap and remaining fully invested is more crucial in the defined benefit separate account business than in the retail or defined contribution markets. "Unquestionably you have to have a much more rigid style focus. If you can't maintain that - even with good numbers - you can lose the account or fail to be included in a search."
"On the mutual fund side, your (net asset value) is stamped on your head every day. It's not measured on as long a basis as the defined benefit business," he added.
Merrill's Mr. Upah said: "A number of funds could be on the borderline as to whether they should be classified in a particular category or not. For historic reasons they were placed in a category and may not correlate with other funds in their category." Also, many categories of Morningstar and Lipper Analytical Services, Summit, N.J., are very broad.
In general, the larger the family, the more likely funds will stick to their stated objectives. That's why Putnam; Vanguard Group of Investment Cos., Valley Forge, Pa.; and IDS Mutual Funds, Minneapolis, feature some of the most typical funds in every stock classification, even international.
"The majors, which compete with other big firms for billions of 401(k) dollars, are more likely to keep a close watch on the competition and offer clearly defined, easily explained products. Smaller boutiques with more limited client bases have more freedom to put out quirky funds that fit the firm's or manager's area of expertise," Mr. Rekenthaler wrote.
Ten years ago, if the same analysis had been done, fund families would have shown lower R-squared statistics on average. "The fund industry was younger and less self-conscious then, and definitions of various fund types weren't fully worked out. Today, however, market forces are pushing many fund companies to offer more predictable products," he wrote.
By objective, growth and income, equity income and aggressive growth funds have the highest R-squared. The growth and small company categories are more diverse, with growth acting as a catch-all for funds that aren't easily pigeonholed and small company funds including both growth- and value-oriented strategies.
