Benign on the surface, Lipper Inc.'s reclassification of domestic equity mutual funds will send shock waves through mutual fund performance rankings.
Everything from portfolio manager compensation, to sales and marketing, to the breadth of a mutual fund company's offerings will be affected in some way by the new system of classifying and comparing mutual funds, according to analysis from Financial Research Corp., Boston.
More than 50% of the retail mutual fund industry's long-term assets -- $1.9 trillion -- will be affected by the Lipper changes, according to the analysis.
Based on performance data from Dec. 31, some of the industry's largest funds -- Fidelity Magellan, Washington Mutual Investors, Fidelity Growth & Income, Putnam Growth & Income, Vanguard Windsor II and American Century Ultra -- would drop at least one quartile in performance comparisons over some one-, three- and five-year periods under the new classification, according to an analysis by Financial Research Corp., Boston.
In fact, eight of the 10 largest domestic equity funds that would be affected by the Lipper changes dropped at least one quartile over some of the time periods.
Fully two-thirds of the 3,200 domestic equity mutual funds (with one-year track records) that FRC studied will be affected by the new system, as those funds are compared more closely with true peer funds. About 3,800 domestic equity funds altogether will be reclassified July 1.
The fund most negatively affected by the new Lipper categories was the Janus Fund, now classed as a capital appreciation fund. When reclassified as large-cap growth, the fund dropped at least one quartile in the one-, three-, five-and 10-year periods ended Dec. 31.
FRC found only two funds rose at least one quartile under the new system. The $39 billion Fidelity ContraFund rose at least one quartile in the one- and three-year periods when it moved out of the old growth category and into the new flex-cap growth classification. The $29 billion Fidelity Advisors Growth Opportunities Fund rose at least one quartile for the year.
A plus for value funds
The overall performance rankings of mutual fund complexes will be affected under the new system; but exactly how will depend primarily on the predominance of value investment products within their fund families.
FRC found the Lipper changes will have the most positive impact on value funds, so value-heavy shops such as Federated Securities Corp., the Oakmark Funds, Neuberger & Berman LLC and The Vanguard Group of Investment Cos. will see their aggregate performance rankings rise, based on an asset-weighted one-year average for their domestic equity funds.
Even Fidelity Investments, most often considered a growth shop but with more than half of its mutual fund assets invested in blend and value strategies, will rise in performance rankings based on the aggregate one-year performance of its U.S. equity funds.
Lipper announced its reclassification system in early December (Pensions & Investments, Dec. 14). The primary evaluation factor in the new process is market capitalization; the second uses historical portfolio and performance information to separate funds into different levels of aggressiveness within each market cap range.
Testing period
Lipper invited mutual fund companies to comment during a six-month period of parallel testing between the old and new classification systems.
"It's a hard prediction to make about what effect these changes at Lipper will have on the market. We're still in the comment period and don't know what the final form of changes to Lipper's fund categories will be. We've run several sets of numbers and the results have been inconclusive so far," said Robert C. Pozen, president and chief executive officer of Fidelity Management & Research Co., Boston, in an interview.
Lipper's 25 new style boxes, he said, "make a lot of sense for funds that are style specific. But it makes less sense for funds, like Magellan for instance, that are not by their nature required to be style specific."
He said he suggested to Steve Lipper, senior vice president of New York-based Lipper, that another box be created that would encompass funds that have the freedom to span investment styles and market capitalizations.
But, Mr. Pozen said, it's very hard to tell how important the Lipper changes will be overall, because Lipper numbers are used extensively by some parts of the mutual fund market but not by others.
For fund managers such as Capital Research & Management Co., Los Angeles, which manage style-specific mutual funds, the Lipper changes are "a step in the right direction. Some of our funds were miscategorized in the past," said Drew Taylor, assistant vice president and co-manager of fund analysis and investment review.
But because Capital Research never has emphasized performance rankings to the brokers that distribute its funds, Lipper's reclassification will have little impact. In fact, Mr. Taylor said, most of the brokers using Capital Research's funds rely on performance data from Morningstar Inc. for fund comparisons.
Mark Naber, managing director of mutual fund consultants The Optima Group Inc., Fairfield, Conn., said Lipper's changes will have important repercussions for institutional investors, and in portfolio manager compensation.
Lipper data are used more often than Morningstar data for fund performance comparisons by defined contribution plan and smaller defined benefit plan sponsors and consultants. Narrowing Lipper's classifications of funds will help sponsors make more informed decisions about the best fund in a particular asset class, Mr. Naber said, although he thinks few funds will be dropped as investment options because of a change in their Lipper ranking.
And because many mutual fund companies use Lipper data for internal purposes, especially for comparing manager performance with peers for compensation purposes, the Lipper changes at minimum have portfolio managers and executives "scrambling to see how they will restructure compensation benchmarks."
In general, FRC found equity funds that have been reclassified by Lipper as value funds will be the biggest beneficiaries in performance comparisons. More than half of the "new" value funds moved up at least one quartile in the periods ended Dec. 31. About half of the funds now classified as growth or aggressive growth dropped at least a quartile.
The reason, according to FRC's analysis, was that in the old Lipper system, value funds were often lumped into the same peer groups as growth funds. During the past few years, when growth stocks strongly outperformed value stocks in the U.S. market, performance of the true growth funds topped that of true value funds in the same classification.
Differing fund sizes
The new system also will better compare funds with different market capitalizations. Recent market conditions favored large-cap stocks, pushing large-cap funds to the top of Lipper's old peer groups, where small-cap and midcap stock funds were sometimes lumped in with bigger cap funds. This was especially true in Lipper's old capital appreciation and growth objectives, FRC found. More than 50% of large-cap equity funds dropped one or more quartiles for the periods ended Dec. 31, under the new system.
Chris J. Brown, author of FRC's mutual funds study, pointed out that Lipper's changes might send some multiproduct mutual fund companies back to the drawing board to fill holes in their fund lineup. Lipper's reclassification will leave Putnam Investments, for example, with six funds in the flex-cap category and six in the large-cap category, but only one each in the midcap and small-cap classes.
