The Dangers of Picking Mutual Funds Based on Style Category

Investors often make the mistake of selecting an actively managed mutual fund solely based on its style category. The style category refers to the classification of mutual funds by the market capitalization of the stocks they invest in, as well as the growth-to-value spectrum. However, it is crucial for investors to pause and reconsider this approach.

The concept of categorizing mutual funds by style traces back to the groundbreaking research conducted in 1992 by professors Eugene Fama from the University of Chicago and Ken French from Dartmouth College. Their work has been widely acknowledged and popularized by investment researcher Morningstar through its well-known style box.

Now, I am not disputing the significance of distinguishing between different styles of mutual funds. Fama and French's research successfully demonstrated that there are indeed systematic differences among styles. However, it is important to note that significant variations exist within each style as well.

It is entirely possible to select a style that appears to outperform all others on Wall Street but still suffer substantial financial losses. On the other hand, one can choose the worst-performing style and end up generating extraordinary profits.

This highlights the presence of two types of risks associated with selecting actively managed funds. First, there is the risk that comes with the fund's specific style (referred to as category risk). Additionally, there is the risk associated with the individual stocks chosen by the fund's manager (known as idiosyncratic risk). In many cases, idiosyncratic risk tends to outweigh category risk, particularly in the shorter term.

Investors must keep these risks in mind when choosing an actively managed mutual fund. Relying solely on the fund's style category may lead to unforeseen and potentially adverse outcomes. A comprehensive evaluation of both category and idiosyncratic risks is essential to make informed investment decisions.

The Risk of Investing in Actively Managed Funds

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%.

Wide Performance Differences

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 Idiosyncratic Risk of Actively Managed Funds

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.