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Which Are Better: Funds That Stick to Style, or Those That Wander?

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With college football on hiatus, and since the yard doesn’t need mowing, what’s a fella to do when Saturday rolls around? I decided to take a look at an issue which has plagued in my mind for some time. Is it preferable to invest in mutual funds and ETFs which hold to their style, or is it better to select funds which can migrate across the landscape in search of alpha? 

Fortunately, Morningstar Principia has a sortable column which measures and ranks a fund’s peer group tracking history. For those who did well, a ranking of “High” is awarded. At the other end of the spectrum are those funds that stray from their pack and receive a rank of Low. The balance of funds are in the middle. 

Why is this important? What if you held a large growth fund when the tech bubble burst and it tracked perfectly with its category average? Why, you would have lost a lot of money! What if you held a fund in the same category, but one which raised levels of cash at that time? It certainly would not have lost as much, and hence, would not have tracked well with its peer group. Therefore, I think it could be said that in bear markets, having a fund with a low tracking score would be best while the reverse may be true in rising markets. 

I used Principia and after separating large cap from small cap, averaging the group using only “A” shares, here’s what I found. In the large cap domestic arena there are 148 offerings with a score of High. The number of funds with a Low score is a paltry 16. Hardly enough for a definitive conclusion. 

Without too much surprise, the Low group had a slightly lower standard deviation. However, as of the end of November, the High group outperformed the Low group in the following trailing periods: YTD, one month, three month, and 12 month. The best at tracking were 2.24% better in the 12-month period. The winner of the three-, five- and 10-year periods were those in the Low group. Better by a minimum of 1.50%. 

In the small cap space, the results were quite different. Those that tracked well did best in every trailing period I considered. The Sharpe Ratio was also slightly better with small caps that had a high tracking score.

My initial conclusions are as follows: With large cap stocks, this issue may not matter. With small cap funds, it may in fact, be something to consider. 

Thanks for reading and have a nice week! 


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