In the U.S., investment research firms have developed a host of domestic style indexes for investors to more accurately assess the performance of their U.S. equity mutual funds. Investment research firms construct the style indexes by assigning all of the publicly traded companies domiciled in the U.S. into specific style categories based on their identified investment style characteristics and market capitalization. By organizing companies in this manner, it is possible to construct a host of meaningful benchmark proxies that can be used by investors in order to more accurately evaluate the performance of their mutual funds.

As one can imagine, the organization of publicly traded companies by investment style and market capitalization is a complex undertaking. Therefore, it is important for investors to have an understanding of the criteria used to construct the style indexes before using them to make any performance assessments of their mutual funds. Here's how two of the most well-known investment research firms construct their benchmarks, and a five-step process to help ensure that you are making an accurate performance assessment.

Three Types of Investment Style Categories
There are three types of equity mutual fund style categories. The first style category is referred to as value because it represents a style orientation of companies that are trading at a discount in relation to their anticipated intrinsic value. Value companies are typically found in depressed industries and in industries that are out-of-favor, and typically exhibit a low price-to-earnings ratio and a low price-to-book value ratio.

The second style category is growth and it typically consists of companies that are expected to have high future earnings growth. Companies assigned to the growth category usually trade at a premium and typically exhibit a high price-to-earnings ratio, a high price-to-book value ratio and a high price-to-sales ratio.

The third style category is core, and it's made up of companies that have a blend of both value and growth characteristics. (For more on ratios, refer to our in-depth Financial Ratio Tutorial.)

Russell Investments and MSCI Barra Style Classification Systems

Two of the most widely known investment research firms are Russell Investments and MSCI Barra. Russell Investments began creating benchmark indexes since 1984 in order for investors to have more valid benchmark proxies. In the global arena, MSCI Barra has been constructing equity indexes for more than 25 years, and recently developed a host of U.S. equity style indexes in order to foster investment performance evaluation.

For the purposes of constructing style indexes, both Russell Investments and MSCI Barra have developed comprehensive guidelines for defining eligible corporate securities and membership by market capitalization, and determining investment style. Based on the criteria listed in the table below, Russell Investments and MSCI Barra assign more than 8,700 publicly traded U.S. companies to style categories in order to build benchmark proxies. Once these benchmarks are constructed, they are used by investors to gauge the performance of their investment options.

Style Category Russell Investments MSCI Barra
Value Style Criteria 1) Relative book value-to-price ratio

2) Institutional Brokers\' Estimate System (I/B/E/S) long-term growth mean

1) Book value-to-price ratio

2) 12-month forward earnings-to-price ratio

3) Dividend yield

Growth Style Criteria Same criteria used as listed in the value style category 1) Long-term earnings per share growth rate

2) Short-term forward earnings per share growth rate

3) Current internal growth rate

4) Long-term historical earnings per share growth trend

5) Long-term historical sales per share growth trend

Core Style Criteria Same criteria used as listed in the value style category Not applicable. Companies that exhibit value and growth characteristics are proportionally weighted to each category.

Comparison and Review of Investment Size and Style Performance
As you can see from the table above, Russell Investments and MSCI Barra use different factors to define investment style. As a result, both absolute index performance and index performance by specific style category will most likely differ during some measurement periods. These discrepancies make it difficult for investors to determine the amount of alpha generated by the portfolio manager. Given this discrepancy, one could make the case that active management has, or has not, added much value for the period, depending on the selected benchmark proxy used to assess the mutual fund's performance. (If you aren't familiar with indexes, see our Index Investing Tutorial.)
Moreover, at the macro level, general themes about the performance of style categories may be affected by the factors used to construct the style indexes, because in some cases an index provider may show value outperforming growth, whereas another provider may show growth outperforming value. This is a significant problem for investors, because it puts them in a compromised position in terms of making a performance assessment, and determining whether they need to make a change with regard to the mutual funds they are using.

Recommendations for Investors
To help investors properly use investment style indexes to make an assessment about the performance of their investment options, we recommend that investors follow a five-step process.

1. Review the mutual fund prospectus.
By doing so, you can understand the investment manager's investment methodology, style orientation and market capitalization range.

2. Examine the characteristics of the mutual fund.
Ensure that it is structured in a manner that is true to the style category and market capitalization specified by the investment manager.

3. Review the makeup of the manager-specified benchmark.
Ensure that it is constructed in a manner that facilitates a fair and accurate performance comparison.

4. Assess the relative performance of the investment option against the investment manager's specified benchmark proxy.

5. Compare the performance of the fund against a similar benchmark proxy established by an independent investment research firm.
This will allow you to reassess the relative performance of the fund.

After these steps have been taken, investors should be in a much better position to properly assess the performance of their mutual fund, and be in a better position to determine if any change needs to be made. (Learn more about the prospectus in Don't Forget To Read The Prospectus!)

The Bottom Line

Style analysis can be a very useful tool for selecting equity mutual funds, choosing the appropriate benchmark proxy, and making an investment performance assessment. However, the manner in which style is defined and measured by investment research firms must be understood before investors can draw any conclusions about the relative performance of their investment options.

Related Articles
  1. Mutual Funds & ETFs

    Top 3 First Pacific Advisors Funds for Retirement Diversification in 2016

    Learn about three mutual funds from First Pacific Advisors for including in a well-diversified retirement portfolio. Discover which fund truly stands out.
  2. Mutual Funds & ETFs

    Top 3 UBS Global Funds for Retirement Diversification in 2016

    Learn about UBS's asset management business, past mutual fund performance and the top three UBS mutual funds to consider for retirement diversification.
  3. Mutual Funds & ETFs

    Invesco’s Top Funds for Retirement

    Here's a list of Invesco investments—retirement funds—that may work for you if you have the time to let them mature over the long term.
  4. Mutual Funds & ETFs

    Top 4 Royce Funds for Retirement Diversification in 2016

    Discover four of The Royce Funds mutual funds suitable for diversifying retirement portfolios that focus on investing in small-cap companies.
  5. Mutual Funds & ETFs

    Top 3 VALIC Funds for Retirement Diversification in 2016

    Learn about the VALIC fund family, its performance relative to its peers and the top three VALIC funds to consider for retirement diversification in 2016.
  6. Mutual Funds & ETFs

    The 4 Best T. Rowe Price Funds for Growth Investors in 2016 (TROW)

    Discover the four best mutual funds administered and managed by T. Rowe Price that specialize in investing in stocks of growth companies.
  7. Mutual Funds & ETFs

    The 3 Best T. Rowe Price Funds for Value Investors in 2016

    Read analyses of the top three T. Rowe Price value funds open to new investors, and learn about their investment objectives and historical performances.
  8. Mutual Funds & ETFs

    Top 3 Lazard Funds for Retirement Diversification in 2016

    Learn about Lazard Asset Management, its long history of strong performance and the top three Lazard funds to consider for retirement diversification.
  9. Investing

    3 Healthy Financial Habits for 2016

    ”Winning” investors don't just set it and forget it. They consistently take steps to adapt their investment plan in the face of changing markets.
  10. Investing

    How to Ballast a Portfolio with Bonds

    If January and early February performance is any guide, there’s a new normal in financial markets today: Heightened volatility.
RELATED FAQS
  1. How liquid are BlackRock mutual funds? (BLK)

    BlackRock, Inc. (NYSE: BLK) mutual funds are very liquid, as are all mutual funds. An investor receives payment for a redemption ... Read Full Answer >>
  2. What is finance?

    "Finance" is a broad term that describes two related activities: the study of how money is managed and the actual process ... Read Full Answer >>
  3. What is the difference between positive and normative economics?

    Positive economics is objective and fact based, while normative economics is subjective and value based. Positive economic ... Read Full Answer >>
  4. Are target-date retirement funds good investments?

    The main benefit of target-date retirement funds is convenience. If you really don't want to bother with your retirement ... Read Full Answer >>
  5. Do mutual funds require a demat account?

    A dematerialized account enables electronic transfer of funds. The account is used so an investor does not need to hold the ... Read Full Answer >>
  6. How liquid are Vanguard mutual funds?

    The Vanguard mutual fund family is one of the largest and most well-recognized fund family in the financial industry. Its ... Read Full Answer >>
Hot Definitions
  1. Short Selling

    Short selling is the sale of a security that is not owned by the seller, or that the seller has borrowed. Short selling is ...
  2. Harry Potter Stock Index

    A collection of stocks from companies related to the "Harry Potter" series franchise. Created by StockPickr, this index seeks ...
  3. Liquidation Margin

    Liquidation margin refers to the value of all of the equity positions in a margin account. If an investor or trader holds ...
  4. Black Swan

    An event or occurrence that deviates beyond what is normally expected of a situation and that would be extremely difficult ...
  5. Inverted Yield Curve

    An interest rate environment in which long-term debt instruments have a lower yield than short-term debt instruments of the ...
  6. Socially Responsible Investment - SRI

    An investment that is considered socially responsible because of the nature of the business the company conducts. Common ...
Trading Center