Drifting Away
by Dr. Felix Kleinstein

Question from respected colleague:
It’s always frustrating when I add a fund to a 401(k) menu and then a month or two later it drifts into another category. Not only do I need funds to fill specific slots, I need them to stay there. Can K⁴ Fund Selection help?

Answer from Felix:

Of course it can! Although there’s no way to guarantee what a fund will do, K⁴ Fund Selection can help you select funds that are much less likely to drift out of the desired category. Not only can you select funds less likely to drift, you can also periodically review the funds to spot potential drifters before they make their move.

Before the Morningstar style box became well-known, most equity funds were free to invest anywhere in the domestic market. Managers moved around from value to growth or large to small caps depending on where they saw an opportunity. The S&P 500 was often used as the benchmark. As investors learned more about asset allocation and the application of Morningstar’s style box, they began looking for mangers who focused in specific styles and capitalizations. The rise in popularity of 401(k)s also added to the need for this type of targeted selection. As a result, more and more mutual funds began to concentrate in specific categories measuring themselves against their category-specific peers and benchmarks. So-called “multi-cap” funds still roam among various styles and capitalizations, but today most funds at least claim to adhere to a specific category.

It’s not just the multi-cap funds that drift around though; others do it, too, whether by design or accident. It sounds like you’ve run into some of them. The best way to avoid them is to identify the signs of a drifter. There are several things to look for and a K⁴ solution for each of them:

• Concentrated funds– those with relatively few holdings – are notorious drifters. Morningstar will place them in a specific category, but as soon as the manager buys or sells a few stocks in a different category, the fund will quickly move.
  -- You can avoid concentrated funds by using the “Total Number of Stocks” filter to require a minimum of 50-60 stocks or even more. These larger portfolios are less likely to rapidly change categories.

• Low R-Squared to the Category Index– is a tipoff that a fund has less allegiance to a particular category. As you know, Klein assigns each category a Category Index that applies specifically to its particular capitalization and style, e.g. the Russell 2000 Value for small cap value and the Russell 1000 Growth for large cap growth. A low R-Squared to the Category Index suggests the fund doesn’t behave like the index over the longer term. It may be “just visiting” the category.
  -- You can use the R-Squared to the Category Index filter to screen out potential drifters. Generally you’d like to see an R-Squared of at least 70; anything lower should raise a red flag.

• A fund with a Best Fit Index other than the Category Index– suggests you do additional research before using it as a representative of the category. If the Best Fit Index is that of another category, that’s a sign that the fund doesn’t have a long-term history of behaving like its current category. Perhaps it’s a multi-cap fund that just happens to have the highest correlation with this particular category.
  -- Use the “Best Fit Index”, “Equity Style Box – Cap”, and “Equity Style Box – Style” filters to check funds’ current affiliations. The Best Fit Index is really a closer proxy for the fund’s style and capitalization category.

• Funds with styles or capitalizations that differ from their reported category– may also be drifters. Morningstar assigns funds to categories based on their last three years’ performance. As a result, it takes some time before the fund is re-categorized. But Morningstar also provides a more current snapshot of the fund’s style and cap in the “Equity Style Box” statistics.
  -- If you use the Equity Style Box statistics as filters, they’ll eliminate funds with current styles or capitalizations that differ from their reported category. When this occurs, it suggests the fund may be in the course of drifting out of the category. As a result, you may not want to use it to represent that category.

Although these statistics can point out funds you may not want to add to your 401(k) lineup, don’t be too hasty to remove existing funds based on this information. Sometimes a fund’s Equity Style Statistics can change for a month or two, and then quickly return to the appropriate category. If you react too quickly, you may needlessly increase turnover. Instead of using these comparisons as sell signals, they are better used to identify funds to watch. This strategy gives you time to identify alternatives, if it does become necessary to remove them from the lineup.

So, K⁴ Fund Selection can help you find funds that are as faithful as Lassie. But use the information wisely! Fund managers may not see it as a compliment if you identify their funds as dogs!