What Are Your Funds Really Investing In?

Few investors would disagree that the best among them are those who look for ideas where others don't.

In reality, though, investors have a herd mentality, chasing investments at the worst possible time. They buy funds, for example, after they've gotten hot, and sell them just as soon as performance cools. It's no wonder, then, that the actual returns most investors achieve are far lower than the fund performance published and touted by fund companies. Often, the root of this behavior can be traced to a misunderstanding about a fund's style. For instance, most investors left value funds for dead in the late 1990s, even though the source of their underperformance was an adherence to a style that kept them out of the market's hottest sectors.

To combat this and similar problems, and to improve the portfolio-building process in general, we introduced the Morningstar Style Box years ago. Its goal was to allow investors to compare and contrast investment decisions more accurately, and to improve the diversification of their portfolios. But while the style box is eminently useful in achieving those goals, it hasn't always clearly captured a manager's thinking.

Take Bill Miller's  Legg Mason Value (LMVTX), for example, a fund that is classified as large-cap blend. For years, a debate has raged about whether Miller is a value or growth investor, with most investors lining up on either side of the fence. Few, however, point to the fact that he draws on elements of growth and value when compiling his funds' portfolios.

This is where our new ownership zone, which debuted on Morningstar.com yesterday, can shed some light. This tool takes the style box to the next level by highlighting the breadth of securities a fund owns, and displaying how those securities are spread across the style box. Indeed, because a stock portfolio is an aggregation of individual stocks, its style is determined by the style and size scores of the stocks it owns. By plotting all of a portfolio's stocks on the style box grid, the range of stock styles included in the portfolio immediately becomes apparent.

Here's how we establish a fund's ownership zone. The portfolio's vertical placement in the style box grid is determined by calculating the asset-weighted size score of the underlying stocks' size scores. Likewise, the portfolio's horizontal placement is determined by calculating the asset-weighted style score of the underlying stocks' style scores.

The plot of the resulting style and size score on the style box grid is called the centroid, and it's represented by the red dot that's now visible in the style box. As for the ownership zone, it is the now shaded area of the style box. This area is intended to be a visual measure of a portfolio's style scope--in other words, the primary area of ownership within the style box. It achieves this goal by encompassing 75% of the stock holdings in a given portfolio, which are centered around the centroid using an asset-weighted calculation.

Take the example of Legg Mason Value. This fund's centroid, which is represented by the red dot in the style box, straddles the blend and growth line. But what's really telling is the fund's ownership zone, which shows that while Miller is primarily a large-cap manager, 75% of the securities in his fund are spread across the breadth of the style box, ranging from value to growth. It's no wonder, then, that while some managers' performance can be heavily dependent on whether their style is in favor, Miller has shown an uncanny ability to do well regardless of what's in favor.

On the other hand, an investor in the Davis-run  Selected American  (SLASX), which is also classified as a large-blend offering, will find that they own a remarkably different fund. Selected American's portfolio has a centroid that straddles the boundary between the value and blend areas of the style box, but its ownership is skewed away from the growth box and tilted heavily towards the value and blend areas of the box. As such, it's no surprise that the fund tends to have a tougher go of things when the market gets speculative.

Similarly, while  Vanguard Selected Value (VASVX) and  Weitz Value (WVALX) both fall in the mid-cap value category, their performance has diverged markedly of late. A look at their ownership zones offers some insights into why this is the case. The former's ownership zone shows that it is a pure mid-cap play, while the latter's demonstrates that it is wide-ranging. As such, in a market that's favored small- and mid-cap stocks over large caps, it's no wonder that the Vanguard fund has posted markedly better results. 

As these examples demonstrate, investors can use the new ownership zone to further clarify the way they combine funds in a portfolio. These zones should also provide more insights into fund performance, potentially helping investors develop longer time horizons. Finally, they demonstrate the value of not thinking too rigidly about growth and value. It's rare that a manager or investment team will own securities that neatly fit into one square of the box, and the key thing for an investor to focus on is their investment style. As long as it is consistently applied, it's more useful to gain an understanding of how the portfolio is spread across the style box than it is to know which corner it resides in.