Chapter 12. Are You in Style?

Once an investor wades through the potential problems with fund names and determines the class of mutual fund shares he or she wishes to own, there is still the issue of investment style, a prominent feature in today's mutual fund world. Investors should build their portfolios based on sensible asset allocations , and to do this they typically consider the mutual fund's style.

In the 1980s, institutional investors started classifying money managers according to their investing style. The two major styles are value and growth, terms that continue in popular use today. Value stocks are stocks that are trading at prices thought to be below their economic value. This often means that these stocks have low price-to-earnings ratios and low price-to-book values. Growth stocks are stocks that are thought to have above-average prospects for earnings growth. Such stocks often have high price-to-earnings ratios and high price-to-book value ratios.

Investors are also concerned with the size of the companies invested in ”clearly, a fund holding large-company, blue-chip stocks can be expected to perform differently from a fund holding small stocks.

In the early 1990s, Morningstar, the top provider of information about mutual funds in the minds of most investors, created a nine- cell style box to describe the investing style of funds that has become very popular with investors. It shows at a glance what the investment strategy of a fund is based on the size of the companies invested in ”small, medium, or large ”and whether the stocks are value, growth, or a blend that is in between.

A style box looks something like Figure 12-1, which indicates a fund that concentrates on large-capitalization stocks based on value principles. A mutual fund concentrating on small growth stocks would have a style box that looks like Figure 12-2.

Figure 12-1. A Style Box for a Large-Cap Value Fund.

Figure 12-2. A Style Box for a Small-Cap Growth Fund.

In theory, style analysis is important because it helps people to invest in the types of funds they are really seeking. By separating funds into the various style groupings, a mutual fund is compared with other funds that follow a similar investment style rather than simply being compared to a market index such as the S&P 500. It would be unreasonable to compare your mutual fund to the population of all mutual funds, many of which are targeting different sectors, different market segments, and so forth.

We saw in Chapter 9 that what at first appears to be a relatively straightforward task ”choosing funds based on their names ”is in fact not necessarily straightforward. Investors can easily be misled into choosing funds that do not in fact meet their objectives as closely as they first assume.

Style boxes help investors avoid some problems that can arise because they misinterpret a fund's name or its investing objective. For example, let's assume you believe in diversification, as you should. You own a fund investing in large companies, a fund specializing in the health sector, and an international-focused mutual fund. You might think you are reasonably well diversified, but a look at the style boxes might convince you otherwise . What if all three funds show up in the style box as large growth funds? In this case, you have little exposure to midcap and small stocks, and you have missed the value side of the equation.

Do style boxes solve investors' problems? They help greatly, but nothing is perfect. Consider one simple example: The Strong Growth Fund is classified as a large-cap growth fund. Therefore, a reasonable presumption is that it holds mostly large-cap stocks. In early 2001, however, only 55 percent of the assets were invested in large-cap stocks, with the other 45 percent mostly in midcap stocks. As an investment approach there is nothing wrong with seeking growth where the opportunities are, but what about investors who are misled when they buy this fund expecting to invest primarily in large-cap stocks?

Insights

Style boxes cannot perfectly capture the strategies of all funds. One fund could be classified in the medium size category, but might actually invest across the board as it seeks out what it believes to be the best opportunities. Also, some mutual funds do not even fit neatly into one of the nine classifications of the style box. For example, convertible bond funds are not readily classifiable because convertible bonds carry an option to convert the bond into shares of common stock.

Morningstar personnel are the first to admit their style boxes are not completely adequate and should not be relied on as the only source when diversifying a portfolio across funds. Morningstar is now planning changes by adding new factors to be used in determining a fund's style. It also plans to incorporate additional information about sector weightings. Of course, it is easy to be critical if we forget what the situation was before the use of style boxes become so pervasive. Without the style boxes, we would have to rely on the funds themselves to tell us what they are doing, and this information might not always be the most accurate. Clearly, the style boxes are an improvement over the previous environment.

Keep the following in mind as you think about which funds to own: Over the 12-month period ending in March 2001, the S&P 500 lost 21.7 percent. Growth and income funds are supposed to be relatively less risky because of the income component, but of the 877 growth and income funds followed by Morningstar, 289 lost more than the S&P 500. ^[1]

^[1] This information is taken from Jonathan Burton, "Were You Sweet Talked By Your Funds?" Mutual Funds , August 2001, pp. 62 “64.