The ABCs of Performance

A. Michael Lipper’s name has become synonymous with mutual fund data, especially performance information.

Lipper heads Lipper Analytical Services, the premier performance-monitoring firm for the fund industry. The Summit, N.J.-based company tracks roughly 38,000 investment companies worldwide, with almost half of those in the United States.

Lipper’s firm monitors not only the open-end funds with which most Americans are familiar, but also closed-end funds, variable annuities and unit investment trusts.

Lipper entered the securities business in 1960, after his graduation from Columbia College (now University) and a tour of duty in the Marines. He was a securities analyst for 13 years before founding Lipper Analytical in 1973 with the idea of providing analytical tools to help fund companies and directors better manage their responsibilities.

The fund industry shrank in size by more than one-third during Lipper Analytical’s first 18 months in business, in the wake of the horrendous stock bear market of 1973-74. But Lipper hung on, and with the fund industry’s boom beginning in the early 1980s, Lipper Analytical quickly became the primary objective source of fund performance data not just for the industry but for an increasingly interested news media and the investing public.

Lipper’s empire includes financial publishing, management consulting and brokerage. Lipper Analytical employs 250 people in offices in Summit, Denver, London and Hong Kong. Lipper was interviewed by Russ Wiles, a mutual fund columnist for The Times.

Times: Since you started your business in 1973, the mutual fund industry’s total assets have exploded from just $47 billion to more than $4.8 trillion. What do you think explains the industry’s success?

Lipper: The fund industry has been blessed by various external forces such as demographics and the shift to defined-contribution retirement plans [including 401(k) plans]. Also, the downsizing of large companies has forced people to realize they have to invest for their own retirement. Certainly, the stock market’s unbelievable performance has been a factor, as have declining interest rates.

But also, several competing investments have become less formidable. We’ve seen many tax shelters go and even real estate has waned. Mutual funds have capitalized on these trends because they are a wonderful way to administer portfolios and gather money.

Times: Do you believe that funds are the way to go for most people, as opposed to trying to pick stocks or bonds on their own?

Lipper: For many investors, funds should be the base. But in addition to that base some investors may want to buy individual securities for which they have specific opinions, and that’s fine. But while a person may have a view on [individual] stocks, he or she might not know as much about money-market instruments or bonds or international stocks. So people may need help with those components of their portfolios, and mutual funds can provide the answer.

The most important thing that you invest when you’re building a lifelong portfolio isn’t your money--it’s your time. If you want to put the time into picking stocks and are able to develop skill, do so. But if you want to spend only 20 minutes a year on your investments, you’re better off using funds.

Times: Your firm plays an important role in providing third-party verification of fund performance numbers, and in making those numbers accessible to the general public through the media. Do you have any tips on how people should evaluate fund performance results?

Lipper: Above all, I don’t think [performance] numbers should be a person’s primary factor for making decisions. All they really should be is an important aid to asking questions. Why did a fund perform as it did? What are the odds of it happening again?

People also need to understand how volatile performance is, in both absolute terms and in the context of rankings. Good investors go beyond the numbers. They find out what the fund manager is trying to do, and they make sure they understand the fund’s objectives.

Times: In evaluating fund performance, are certain time periods better than others?

Lipper: What you want to see is a fund’s performance over two or three investment cycles. From a market peak to trough to peak again constitutes one cycle. But we’ve been in such a strong stock market for so long that you couldn’t use that as a measure for more than a handful of funds [because the last true bear market was in 1990].

So we tend to favor five or 10 years as good, practical performance measures. As for one-year performance, all it’s good for is determining if a longer trend is still continuing. Using performance over periods shorter than a year is like taking your temperature. If it’s low, for example, all it really tells you is that something isn’t normal, but it doesn’t tell you what’s wrong.

Times: Do you put credence in five- or 10-year performance numbers if a fund hasn’t had the same manager the entire time?

Lipper: Usually, yes. Because even when managers are replaced, they typically are replaced in kind, so there’s not much change in policy. Certainly there may be a noticeable difference in skill, but that’s not always the case.

Times: Unlike Morningstar Inc. and the Value Line Investment Survey, your firm does not subjectively rate funds based on their performance. Why not?

Lipper: Because each investor is different. I don’t think it’s appropriate to make a judgment on a fund that might be right for you but not for your sister or brother, your mother or father, or your child. Investing is an art form, and there’s a danger in oversimplifying. Also, if you’re a typical fund investor, you probably own a minimum of three funds. We shouldn’t be making a judgment about Fund A without knowing what your Funds B and C are.

Times: Your firm has done some research indicating that the various “star” ratings used by subjective rating services aren’t necessarily good predictors of future performance.

Lipper: We’ve done that, focusing on periods when the market was going down. Our issue isn’t with Morningstar per se, but with the use of “risk-adjusted” performance. I think people see this term and think a fund will give them protection on the downside. We don’t think the evidence supports that. We haven’t had a market decline of any length since 1994, so it’s hard to test whether the star ratings will protect you.

Plus, risk-adjustment measures are somewhat arbitrary, and they’re backward-looking. Another issue, when you develop any ranking system, is placing a fund within an appropriate peer group. No peer groups are perfect, including those that we have developed. Some of [Morningstar’s] have been particularly bothersome, such as ranking junk-bond funds with high-quality bond funds. Any overreaching system will have defects.

Times: You’ve been monitoring funds for years, and you’ve seen many fund managers go from hot to cold. Has the difficulty that most active fund managers have had beating the market made you a fan of passive “index” funds that simply track the market?

Lipper: My view is that you should consider index funds along with actively managed funds for the domestic-stock portion of your portfolio.

You need to divide indexing into two pieces. First, funds that try to replicate the Standard & Poor’s 500 index have had a very good record, because the S&P; 500 has done very well. But if you eliminate the S&P; group and examine indexing in other areas such as bonds, small stocks or international stocks, you find that the approach hasn’t done as well [relative to using active managers].

I expect to see times when even the S&P; 500 funds don’t flourish. These funds do have low expenses and have been helped by the fact they hold no cash at a time when the market has been rising. Also, the changes taking place in the U.S. economy have favored the large, multinational, consumer-based companies that make up a big part of the S&P; 500.

Will these factors continue in the future? To some degree, yes. But there will be times when the top companies underperform. As it is, they’re not growing as fast as smaller companies, yet investors are paying a premium price for the big blue chips. At some point, the premium will become too high.

Times: Any general tips or suggestions for people when it comes to picking funds?

Lipper: The key question people need to focus on is not how much money they’re going to invest but how much time. People who aren’t willing or able to make the time commitment may need a financial advisor. The investing game has gotten very complex.

The second key question involves the length of a person’s investment time horizon. Frankly, most of us run the risk of living too long, so we will need substantial levels of capital--much more than many of us think. That means individuals need to save more and use equities where they can.

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Profile

Name: A. Michael Lipper

Business: Chief executive of Lipper Analytical Services, which categorizes and monitors the performance of approximately 38,000 investment companies, including virtually all U.S. stock, bond and money market mutual funds.

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Personal: 62 years old; born and raised in New York City; resides in Summit, N.J., with wife, Ruth; has four grown children.

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Background: Earned degree in finance and Middle Eastern history from Columbia College; served in Marine Corps, then worked as a securities analyst for Bank of New York, Burnham & Co., Reynolds & Co. and Arthur Lipper Corp. before founding Lipper Analytical Services in 1973. Lipper is a chartered financial analyst and past president of the New York Society of Security Analysts. He has served on various committees of the New York Stock Exchange, Securities Industry Assn. and other organizations.

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Products: Lipper’s fund data, including historical information since 1960, is sold primarily to institutional customers. The company does not market its material to individual investors and does not make subjective judgments of individual funds’ performance. Limited information, including stock and bond fund industry overviews, can be viewed on the firm’s World Wide Web site at https://www.lipperweb.com

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Source: Lipper Analytical Services