You may be familiar with the phrase "compared to its Lipper Average," a line repeated in many TV and radio advertisements for mutual funds. It sounds impressive when a mutual fund company boasts about one of its products "beating" its Lipper Average, even if a lot of the audience does not know the meaning behind the phrase.
The Lipper Average is a product of Lipper, Inc., which also publishes the Lipper Rating System. Mutual fund companies have relied on Lipper since the 1970s and 1980s, but the company expanded to provide more direct services to the investing public.
As of 2015, Lipper is among the world leaders in investor-centered fund research tools. Its research covers more than 215,000 share classes and more than 115,000 funds across 60 countries.
Lipper Classifications Methodology
According to Lipper, the company uses a U.S. Diversified Equity, or USDE, fund classification strategy. The USDE model is not universally applicable since many Lipper-rated funds are foreign funds, so Lipper tries "to keep the standards for classifying international funds as close to the USDE model as possible."
The USDE model was introduced in September 1999. This model separates the classification process into two steps. First, a fund's market capitalization is considered. Only afterward is the fund's style classification assigned. Style is based on the fundamental characteristics of each holding in the fund from the data Lipper receives from the fund companies themselves as well as independent data providers.
Every fund has different values assigned based on various characteristics. For example, funds in the Diversified Equity classification are judged based on price to earnings (P/E), price to book (P/B), price to sales (P/S), return on equity (ROE), dividend yield and, if available, three-year sales growth. Lipper considers all of these when determining the style for the fund.
To be classified as large-cap, at least 75% of the fund's weighted equity assets must be concentrated in the large-cap threshold. The same 75% model is applied to mid caps and small caps as well. By Lipper's own admission, there is more statistical flexibility for mid- and small-cap funds in how their portfolios are constructed.
After market cap is sorted out, a fund's style needs to be assigned. This is accomplished through something Lipper calls the "individual Z-score" for each period. For each characteristic considered, such as dividend yield or return on equity, a Z-Score is calculated by subtracting the index-weighted average score from the fund's characteristic value-weighted average and then divided by the characteristic index-weighted standard deviation.
The Lipper Average
The Lipper Average represents the average annual return of a fund among its peers, as categorized by Lipper Index. There are several different Lipper indexes, each one consisting of the 30 largest mutual funds for any given category. Categories are grouped by sector, industry, country and market capitalization, meaning a mutual fund might be above its Lipper Average for the sector but below the Lipper Average for funds of its size.
The Lipper Rating System
The Lipper Rating System is a five-tiered, five-category classification system that separates all funds into quintiles. The lowest 20% in a category gets a "1" rating. The next 20% is given a "2" rating. The middle 20% is given a "3" rating, while the next 20% is given a "4" rating. The top 20% is granted the title "Lipper Leader" in the category.
Lipper once focused primarily on two categories: consistency of return and preservation of capital. Two other metrics, total return and expense ratio, have been added more recently. In addition, U.S.-based funds get a separate rating for tax efficiency. According to the company, this rating system is designed to create a simple, easily understood scorecard that helps investors emphasize certain priorities.
All ratings are computed and compared across different portfolios and fund types. For example, scores for total return, consistency of return, expense ratio and tax efficiency are measured for all Lipper classifications such as large-cap core, preferred share/callable bonds, general U.S. Treasury and many others. The scores for preservation of capital are separated into three broad asset classes: equity, mixed-equity and bond funds. Funds are only ranked against their peers. All scores are computed independently and no fund receives a summary score; Lipper wants individual investors to decide which categories should be weighted most highly, so it does not aggregate in any way. Scores in every category are subject to change monthly. Each score is also divided into several periods: three-year, five-year, 10-year and overall.
The Hurst Exponent
Lipper uses a mathematical device known as the Hurst exponent, or simply "H exponent," to separate the wheat from the chaff in terms of consistency. This indicator measures the capacity to produce without excessive volatility, which Lipper then takes and applies to its different peer groups. Lipper then separates funds into three groups: those with an H exponent greater than 0.55; those between 0.55 and 0.45; and those under 0.45.
The Lipper Leader Rating
Much like Morningstar or Standard & Poor's, other mutual fund rating systems, Lipper publishes a list of what it considers to be the best funds in the business. Any mutual fund or ETF that makes it into the top 20% of all funds scores as a Lipper Leader.
Note that Lipper Leader classifications are only good for one score category. For example, a bond ETF might be a Lipper Leader for preservation of capital but not for consistency of return. In most cases, you see a fund refer to itself as a "Lipper Leader for Preservation" to help avoid confusion on this point.
Separating fund leadership by score category is a noticeable difference between the Lipper system and other mutual fund rating methodologies. Only Lipper includes five different kinds of leaders among its five-rating criteria, and it is also the only leading fund rating service to place specific emphasis on the persistence of good fund performance.
One drawback of the Lipper Leader system is the 20% threshold. As new mutual funds get introduced, the size of each quintile necessarily grows as well. This means some funds may get bumped into the Lipper Leader category without necessarily improving in their score; some might even get slightly worse over time, yet go from the 21st percentile to the 20th percentile because of an influx of new competitor funds.