Lipper’s New Rankings Toughen the Task of Assessing Performance

In the coming days and weeks, mutual fund companies will start mailing out their third-quarter statements. And those funds that did reasonably well will also start touting their performance in ads in the personal finance magazines and in newspapers.

You know the ones: “In the past 18 months, we were the No. 3-ranked small-cap biomedical Pacific-Asia fund that doesn’t invest in Japanese stocks!”

Unfortunately for consumers, the whole business of judging a fund’s performance just got a lot more confusing, thanks to recent changes by an influential mutual fund tracking firm. And this could lead investors to mistakenly dump perfectly good funds or, conversely, invest in mediocre ones, analysts fear.

As an example of the potential for confusion, take a look at the Vanguard Capital Opportunity fund.

Shareholders of this $720-million portfolio will find it’s up nearly 44% year to date and up more than 19% annually over the last three years through Sept. 30.

Sounds terrific, especially in light of the fact that the average domestic stock fund is up just 5% year to date and has returned less than 16% a year over the last three years.

But financial planners recommend judging a fund based on its long-term performance relative to funds that invest in similar securities. Exactly how good are Capital Opportunity’s numbers when pitted against its peers?

The answer depends on whom you ask.

Chicago-based fund tracker Morningstar Inc., one of two major fund research services, classifies Capital Opportunity as a “mid-cap growth” fund. In broad terms, that means it tends to invest in medium-sized companies whose earnings are growing rapidly and whose shares trade at relatively high price-to-earnings ratios.

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Among its mid-cap growth peers, Capital Opportunity ranks as 56th-best-performing out of 252, based on its three-year record through Sept. 30, according to the folks at Morningstar. Another way to put it: Capital Opportunity ranks in the top 22% of its peer group, based on its total returns since Sept. 30, 1996.

Simple enough, right? Well, not quite.

Rival fund tracker Lipper Inc., based in New York, has its own fund classification system. (The Times relies on Morningstar’s classification system for its quarterly “Top Funds” lists and uses Lipper’s service for daily and Sunday fund data.)

For years, Lipper grouped diversified U.S. equity funds, for the purposes of ranking them, based on what the funds’ stated goals were.

For instance, a fund that sought to provide investors with exposure to growth stocks and some dividend income might have been classified as a “growth and income” fund. At the same time, a fund whose goal was to provide investors with a little bit more income and a bit less growth might have been labeled an “equity-income” fund.

Conceding that these objectives are amorphous at best, Lipper recently switched to a new system that categorizes funds based on the types and sizes of stocks the portfolios actually own. Morningstar adopted this approach in 1992.

Lipper’s new system closely resembles Morningstar’s. In fact, it even uses many of the same category names--such as “large growth” and “small value.”

But because Lipper’s new system is not exactly the same as Morningstar’s, it has the potential to create confusion for mutual fund investors as they go about assessing funds.

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For example, Lipper, like Morningstar, now lumps together some domestic stock funds in a category called “mid-cap growth.”

But the precise definition Lipper uses to classify funds as such differs. Under Lipper’s system, Vanguard Capital Opportunity would rank as the 38th-best-performing mid-cap growth fund over the last three years out of 149 portfolios.

That would put it in the top 26% of its peer group, not the top 22%, which would still be a fine ranking. That is, if Lipper considered Capital Opportunity to be a mid-cap growth fund in the first place.

It does not. Instead, Lipper’s new system groups Capital Opportunity with so-called multi-cap growth portfolios. These are funds that invest in growth-oriented companies of all sizes--small, medium and large.

Analysts generally applaud Lipper for creating this category, since it reflects the real-world way some fund managers invest. By doing so, Lipper is refusing to penalize managers who like to invest in promising small companies and hold them as they grow to become medium-sized companies and then large blue-chip names, as software giant Microsoft has done over the last 15 years.

But as some funds fall into different categories within the Lipper and Morningstar systems, so too will their relative performance appear different.

For example, whereas Morningstar’s system would lead you to believe that Capital Opportunity has been better than average over the last three years, you’d think that the fund is just plain average if you rely on Lipper’s multi-cap growth category rankings.

In fact, based on its three-year record through the end of the third quarter, Capital Opportunity ranks a mediocre 113th out of Lipper’s 236 multi-cap growth funds--and its total returns are actually below that of the average multi-cap growth portfolio.

Frustrated? Just wait.

Further complicating the situation is that for the time being, Lipper will continue to provide its clients--including fund companies, financial advisors, media outlets and financial Web sites--with rankings based on its old fund-classification system as well.

Under that system, Lipper considered Capital Opportunity a “capital appreciation” fund. And among capital appreciation funds, Capital Opportunity ranks 74th out of 173 (the 43rd percentile) based on its three-year returns through the end of the third quarter.

To recap, if you go by Morningstar’s system, Capital Opportunity is a fantastic fund, beating 78% of its peers over the last three years.

Relying on Lipper’s new system, the fund appears decidedly worse, beating just 57% of its peers.

And if you go by Lipper’s old system, Capital Opportunity looks downright average.

So, depending on the system at work--say an investor looks at a magazine using Lipper and a newspaper using Morningstar--the investor might reasonably want to buy, hold and sell shares of the very same fund.

Not to mention that the fund companies can “shop” for the best system rating to use in ads and promotional materials.

Notes Chris Brown, a mutual fund analyst for Financial Research Corp. in Boston: “Because fund companies are in a position to pick and choose [which system] to use for comparative purposes, this could add to a lot of confusion for consumers.”

For fund investors, this all means you’ll have to be more careful in assessing what funds say about themselves. Some tips:

* Pay close attention to all asterisks in fund ads. If a fund boasts of being one of the best funds in a category, it must tell you which fund-ranking system it is basing that claim on--and how many funds are in the category.

* If a fund relies on Lipper data to boast of its ranking, check which Lipper system is being used--the old system or the new one.

* In tracking and judging your portfolio of funds, it’s probably best to stick with categorizations and ratings from Morningstar or from Lipper, and not mix and match. Otherwise you may risk mucking up your asset allocation plan.

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Times staff writer Paul J. Lim can be reached at paul.lim@latimes.com.