Investors should think twice before picking an actively managed mutual fund according to its style category. By “style category,” I’m referring to the widely used method of grouping mutual funds according to the market-cap of the stocks they invest in and where those stocks stand on the spectrum of growth-to-value.
This matrix traces to groundbreaking research in 1992 by University of Chicago professor Eugene Fama and Dartmouth College professor Ken French, and has since been popularized by investment researcher Morningstar in the form of its well-known style box.
In urging you to think twice before picking a fund based on this matrix, I’m not questioning the existence of important distinctions between the various styles. Fama and French’s research convincingly showed that there are systematic differences between them. My point is that there also are huge differences within each style as well. You can pick a style that outperforms all others on Wall Street and still lose a lot of money, just as you can pick the worst-performing style and turn a huge profit.
This points to the two types of risk you face when picking an actively managed fund. You have the risk associated with the fund’s style (category risk) and you also have the risk associated with the particular stocks that the fund’s manager selects (so-called idiosyncratic risk). Idiosyncratic risk often overwhelms category risk, especially over shorter periods.
To illustrate, consider the midcap-growth style. As judged by the Vanguard Mid-Cap Growth ETF VOT, this style produced a 28.8% loss in 2022. Yet, according to Morningstar Direct, the best-performing actively managed midcap-growth fund last year produced a gain of 39.5%, while the worst performer lost 67.0%.
This best-versus-worst performance spread of over 100 percentage points is illustrated in the accompanying chart. Notice that the comparable spread was almost as wide for many of the other styles as well. Though I haven’t done the research to compare 2022’s spreads with those of other calendar years, I have no reason to expect that they on average were any lower.
“ The only way to eliminate idiosyncratic risk when investing in particular styles is to invest in an index fund.”
The only way to eliminate idiosyncratic risk when investing in particular styles is to invest in an index fund benchmarked to the style in question. If you are enamored of a particular fund manager and willing to bet he will significantly outperform the category average, just know that you also incur the not-significant idiosyncratic risk that the fund will lag by a large amount.
The bottom line? By investing in an actively managed fund in a style category, you will be incurring the risk not only of that category itself but also the not-insignificant idiosyncratic risk of that particular fund. Fasten your seatbelt if that’s the path you take.
Mark Hulbert is a regular contributor to MarketWatch. His Hulbert Ratings tracks investment newsletters that pay a flat fee to be audited. He can be reached at firstname.lastname@example.org