Our Style Box Should Help You, Not Bind You

The Morningstar style box can provide extremely valuable assistance when you’re constructing and monitoring your fund portfolio.

It enables you to know what your funds really own and how they invest, which is sometimes quite different from what their names and literature suggest. The names don’t have to be misleading to cause some confusion. For example, you might own a domestic blue-chip fund, a communications fund, and an international offering, and think that your portfolio is reasonably diversified. If all three portfolios currently land in the large-growth box, though, that diversification might be more apparent than real.

By using the style box to find out what types of stocks or bonds a fund actually owns, you can build a portfolio that represents a wide variety of securities, and therefore be better prepared when one sector of the market, is out of favor--or so in favor that it becomes dangerously overpriced.

Having funds assigned to categories that are based on where they land in the style box also allows you to compare a fund's performance against more-appropriate peer groups. Rather than evaluating an offering against the universe of all funds--which would include many portfolios that target entirely different market segments or use vastly different strategies--using Morningstar category averages enables you to see how a fund stacks up against its true peers.

However, in some ways, a strictly style-box-centered investment strategy can be detrimental. Here’s a few ways that could happen.

Most obvious is a guideline we’ve often mentioned: You don’t have to own a fund from each of the nine sectors of the equity style box. That would be overkill, and with that many funds--or more, if you add a couple of international funds to the mix--you may find yourself owning more funds than you feel comfortable monitoring. Owning a few funds of various styles fulfills the same function.

More subtly, restricting yourself to style-box filling can inadvertently lead you to ignore funds that don’t fit neatly into a box. For example, convertible-bond funds provide an attractive option for investors who want to participate in the stock market but want a lower-volatility alternative than having all their money in pure-stock funds. And there are some excellent convertible funds available--see our  Analyst Picks for the convertible-bond category.

If you focus too closely on whether you’ve got a small-value fund to match your small-growth, say, and a large-blend on top of your mid-blend, it would be easy to forget all about convertible-bond funds. With a paltry $8 billion in assets, this category clearly has escaped the notice of most investors. (Recent Wall Street Journal articles indicate that the convertible market might face short-term problems as a result of the problems at Kenneth Lipper’s convertible hedge fund, but those woes shouldn’t be a permanent condition.)

Rigidly adhering to stocking the style-box could also cut you off from a great fund just because you already own a fund from that category. For example, Selected American (SLASX) has long been among the best choices among large-cap value funds. Shareholders of that fund might think it would be redundant to own, say, American Funds Washington Mutual (AWSHX), or Dodge & Cox Stock (DODGX), which are also large-value offerings. But the latter two funds, both of which are outstanding, tend to use more traditional value strategies, and thus often perform quite differently than Selected American--or, for that matter, than another great large-value choice, Bill Miller’s Legg Mason Value (LMVTX).

Overzealous style-box followers might also feel compelled to sell one of the above funds if they also own Oakmark Fund (OAKMX), because that fund, once a mid-value offering, has moved to the large-value box. Don’t do it! At least, not for that reason alone.

Finally, some funds are flexible in their strategies--they may reside in a mid-cap category, but are really all-cap funds that jump to where the best opportunities are. There’s no logical reason you couldn’t own a strict mid-cap fund in addition to a good flexible fund such as Mainstay MAP Equity (MUBFX), even if their portfolios currently reside in the same style box.

In short, by all means allow the style boxes and the categories to ease your investing decision-making. Just make sure the boxes don’t turn into handcuffs.