Lipper’s New Categories May Look Like Morningstar’s, but They’re Not

In nearly every industry, competitors fight to set the standard. In personal computing, Microsoft beat out Apple. In VCRs, VHS made Beta obsolete. As for music, how many of you still own an eight-track player?

The same competition exists among mutual fund tracking services, a small and seemingly innocuous industry but one that affects investors’ everyday lives and decisions.

For instance, the ads that tout a certain fund as No. 1 among its peers or the ones that make us consider buying one fund over another are usually based on rankings maintained by fund-tracking services. And how a fund fares depends largely on how a fund tracker categorizes it--that is, which funds it is pitted against.

Give Lipper Inc. credit for being among the first to categorize funds 25 years ago. But the New York-based company shot itself in the foot by sticking way too long with an antiquated system that categorizes mutual funds based on their stated, often vague, “‘objectives.”

Categories such as “growth and income,” “equity-income” and “capital appreciation” hold little meaning to most individual investors, said Columbus, Ohio, financial planner Peggy Ruhlin. “We stopped using [those terms] years ago,” she said.

Enter Lipper rival Morningstar Inc. Two years ago, the upstart Chicago firm began categorizing funds based on the market capitalization, or size, of the companies whose stocks they owned and on their investment “styles”--two characteristics that explain a great deal about a fund’s performance.

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Sure, the system has its flaws. For instance, it penalizes fund managers for straying from the categories or “style-boxes” they’re assigned to, even if it’s in the best interest of investors.

But Morningstar’s system was simple to understand. A fund that invested in large, growth-oriented companies was categorized as a “large-cap growth fund.” Funds that invested in small companies whose shares are undervalued based on their assets or earnings were categorized as “small-cap value funds.”

Over the next two years, Morningstar would come to define the very language of mutual funds and would overtake Lipper as the industry’s dominant player. (The Times uses Lipper’s current categories for its Sunday mutual fund tables, on C13 today, and Morningstar’s categories in its quarterly investment reviews. The next review will appear Sunday, Jan. 3.)

Last week Lipper acknowledged--finally--that its fund ranking and classification system was outdated (something we all knew, just as we know that Apple’s operating system is still better than Microsoft’s Windows 98). It announced plans Wednesday to create a whole new system that, like Morningstar’s, will consider the market capitalization of the companies whose stocks are held by a fund. In addition, it will factor in the varying levels of “aggressiveness” of each fund.

But Lipper may be too late.

“It’s going to be very hard to retrain people” to speak a new mutual fund language, said William Dougherty, with the Boston-based mutual fund consulting firm Kanon Bloch Carre. Lipper “had a chance to do this 10 years ago but didn’t.”

Added Jim Stratton, manager of the Stratton Growth Fund: “I’m not certain there’s a crying demand out there for a new system.”

Especially one that’s this detailed. Lipper is proposing a system that could categorize U.S. diversified stock funds into one of 25 categories, ranging from “micro-cap aggressive equity” to “large-cap income equity.” (By contrast, Morningstar has nine categories for these funds.)

Lipper says it will soon categorize funds based on five different asset sizes: large-cap, mid-cap, small-cap, micro-cap and something called flex-cap. Funds will also be classified based on five different levels of aggressiveness--aggressive equity, growth equity, general equity, value equity and income equity.

Be careful here: Lipper is using the terms “growth” and “value” differently from the way Morningstar does. In Lipper’s language, the terms are labels to describe risk. Morningstar, however, uses those terms in a more traditional way to describe stock-picking styles based on earnings growth and assets.

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As you can see, having more than one language--or standard--in the mutual fund industry is going to be confusing. So here are some things to keep in mind:

* Don’t be surprised if your fund tweaks its style to adhere to a new Lipper category. Just because individual investors speak Morningstar’s language doesn’t mean fund companies won’t try to be bilingual.

Morningstar sells its information to financial planners and retail investors. Lipper, on the other hand, makes its money selling data to the fund companies and their directors. So “while the fund marketing department is going to want the fund to conform to Morningstar’s system, because that’s what the world is using, the fund manager is going to manage to the Lipper categories, because that’s probably what he or she will be benchmarked internally against,” said John Rekenthaler, Morningstar’s director of research.

* Mutual fund ads will be more boastful. “The more boxes or categories you have, the more funds you will have at the top of each category,” notes Coral Gables financial planner Harold Evensky. “Funds will stand a whole lot better chance of being on top of a Lipper category than a Morningstar.”

Indeed, according to Lipper, the minimum number of funds to constitute a category is just seven. Right now, four of the proposed 25 categories aren’t considered real categories because there aren’t enough funds to fill them. But once there are, you could have a fund claiming to be the No. 1 mid-cap income equity fund, according to Lipper, when in fact it beat out just six other competitors.

* Sophisticated fund investors may find Lipper’s new system useful. That’s because Lipper’s categories will provide more specific--some might say more accurate--descriptions of what a fund actually does. This lends itself to fairer comparisons of a fund.

* For asset allocation purposes, stick with Morningstar’s system. Some of you may think that because Lipper has 25 U.S. stock fund categories, you’ll need to be invested in 25 different types of stock funds to be properly diversified. No financial planner in his or her right mind should be advising you to buy 25 different types of mutual funds to properly allocate your holdings.

In fact, for the purposes of comparing your funds in general, rely on Morningstar’s categories. At least until Lipper can work out the kinks in its system--and until it can prove that learning a new mutual fund language is really worth it.

After all, because Morningstar is the standard now, the burden is on Lipper.

Times staff writer Paul J. Lim can be reached at [email protected].