Several years ago, Morningstar’s Don Phillips invented what is called a style box, now widely used by the investment community to categorize mutual funds according to investment characteristics of their portfolios. Fund categorization allows investors to diversify the asset-allocation of their portfolios by choosing a selection of funds according to varying degrees of risk and return.
A stock (equity) style box is divided up into nine, equal-sized squares in tic-tac-toe fashion. The vertical axis represents a stock fund’s style characteristics by three company sizes – large, medium, and small. The horizontal axis has three investment objectives, or styles – value, blend (stock/bond mix), and growth. The bond (fixed-income) style box reflects a bond fund’s style characteristics by using the vertical axis for credit-quality (investment grade and non-investment grade) and the horizontal axis to gauge interest rate sensitivity (duration).
What Funds Go in Which Square?
You can think of a style box as a kind of “investment map,” which clearly indicates where you are and/or where you’re going in the world of investing.
In stock funds, a company’s size, as measured by market-cap (a company’s share price x shares outstanding), is presumed to be an indicator of relative safety. Larger companies are generally considered to be less risky than smaller companies, with mid-size companies falling somewhere in between.
In terms of investment style, value stock companies are seen as being under priced by the marketplace, so their valuations and earnings expectations are lower than the market average, and they often are dividend payers. The growth category assumes higher than average market valuations and earnings growth with the potential for significant price appreciation. A fund in the blend, also referred to as core, category will provide a mix of companies with both types of investment styles.
Bond funds are categorized by credit-quality (the risk of default) and duration (sensitivity to interest rate changes). Investment grade bonds are categorized as high credit-quality if issued by the U.S. government and its agencies or issuers with AAA and AA rated bonds. The investment grade medium credit-quality category is for those bonds with A and BBB ratings. Bonds rated BB and lower are considered high-yield (“junk”) investments with low credit-quality. The shorter a bond fund’s average duration, the lower its price volatility and yield (interest or coupon rate of the bonds). As a bond fund’s average duration increases to intermediate and long-term categories, both price volatility and yield increase accordingly.
Square Pegs in Round Holes
Some mutual funds have characteristics that do not fit nicely into the standard nine-square categorization of a style box. There’s no simple solution to this dilemma other than to recognize that these exceptions exist:
• Money market and stable value funds are essentially cash-equivalent investments and do not have a designated square in either an equity or fixed-income style box. You wouldn’t be far off the mark by categorizing these funds as short-duration, high credit-quality in a bond style box.
• Funds described as hybrid, balanced, asset-allocation, life-cycle, and target-date all have one thing in common – their portfolios contain a mix of stocks, bonds, and, in some cases, money market instruments. To be able to categorize these funds correctly, you would have to apportion their stock and bond components according to their corresponding style boxes.
• Broad-market index funds cannot be categorized by a single style box square. For example, total stock and bond market index funds would use all nine squares of their respective style boxes. Large, mid, and small-cap stock index funds would use all the horizontal squares for their respective categories.
• Specialty funds, sector funds, and “go anywhere” funds, in most cases, defy any precise categorization. Accordingly, deciding on a “best fit” to their risk-return characteristics is quite simply a judgment call.
The Style Box as a Portfolio Management Tool
There are a number of ways fund investors can use a style box:
• As a beginning participant in a retirement plan, it would be worthwhile to plot all your plan’s investment options in equity and fixed-income styles boxes.
• For retirement plan participants with existing portfolios, the same plotting exercise as previously mentioned is a worthwhile annual procedure to simply assure them that their desired portfolio diversification is on course.
• If your spouse is participating in a different retirement plan, you can use style boxes for each other’s portfolio to compare notes in order to rationalize your respective investment strategies.
• Before adding new funds to a portfolio, a “plotted” style box gives you a comprehensive view of your stock and/or bond positions to guide your selection.
A style box should be used as a dynamic portfolio management tool and not as something you look at once or twice in your investing lifetime. Simply stated, a style box allows fund investors to “see the forest, and just not the trees,” which should translate into making better investment diversification decisions.