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The Style Box: Description, Not Prescription

Facts and myths about the ubiquitous nine-box grid.

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The goal of the Morningstar Style Box, which we rolled out in 1992, was to create an easy-to-use system for classifying funds based on what securities a fund actually owns. We map stock funds into one of nine boxes based on the size of the companies in which they invest and their holdings' aggregate style characteristics (value, core, and growth), and we determine bond funds' style-box positioning by looking at their overall credit-quality and interest-rate positioning.

Over the past 15 years, the nine-square style box has gained a lot of traction among institutions, advisors, and individual investors, and it has become the industry standard for classifying and categorizing funds.

At the same time, however, the style box has also come under fire. Critics have asserted that Morningstar believes style-pure funds are better than freer-ranging offerings, for example. They've also argued that Morningstar polices funds based on their style-box placement and will blow the whistle when a fund veers too far from where it has landed in the past. Neither assertion is true.

It's time to clear up some misconceptions surrounding the style box. Here's what the style box does--and doesn't--do.

  • Describes how funds really invest.
    Morningstar created the style box--and the corresponding category system--as a way to describe what funds actually do, not what they say they do. Before the advent of the style box, investors had only prospectus objectives--such as growth and income, equity income, and growth--to help them sort among funds. The trouble with prospectus objectives is that funds with the same objectives can pursue radically different strategies.
  • For example, both  Parnassus Equity Income (PRBLX) and Nicholas Equity Income (NSEIX) use a prospectus objective of "equity income." But the former focuses on large companies with both growth and value characteristics and has a whopping yield of more than 4%. The latter, meanwhile, buys budget-priced stocks across the market-cap spectrum and has a yield that's only slightly higher than an S&P 500 Index fund. Thus, we think it's more helpful to classify the Parnassus fund as a large-blend offering and the Nicholas fund as mid-cap value than to lump both together in the equity-income bin.

  • Makes it easier to gauge fund performance.
    Although indexes are one way to evaluate a mutual fund's performance, Morningstar's style-box and category system are arguably an even better way to assess how well a fund is doing its job. That's because you can't actually invest in an index, but a fund's category is composed of its true peers--active and index funds alike--that one can actually invest in.

  • Helps investors create diversified portfolios and guard against overlap.
    In addition to describing what funds do and helping investors assess performance, Morningstar's style-box and category system can aid advisors in building a well-diversified portfolio.

    For example, an investor might think a portfolio composed of a world-stock fund, a domestic large-cap value offering, and a financials sector fund is diversified. But by drilling beneath the surface and checking the funds' style boxes, the investors might find that all three land in the large-value style box and will tend to perform in a similar fashion.

    Checking a portfolio's style-box distribution can help investors determine if their portfolio has faux or real diversification.

  • Doesn't box in managers against their will.
    Although the style box helps describe and categorize funds, that doesn't mean we think managers need to stay in a single box forever and ever. Funds pursuing consistent strategies can and do change style boxes, and our analysts don't critique a fund simply because that happens.

    For example, over the past few years, a number of price-conscious managers, such as Wally Weitz at  Weitz Value (WVALX) and  Weitz Partners Value (WPVLX), have found attractive picks among larger companies, even though their funds' holdings have concentrated most heavily in the mid-cap range. Thus, their strategies have remained consistent, but their style boxes and categories have migrated to the large-cap row from their former homes in the mid-cap portion of the box.

    Weitz's funds' "graduation" into large-cap style boxes and categories is consistent with his bargain-hunting strategy. Moreover, the funds' embrace of large caps doesn't coincide with a dramatic increase in asset size. In such a situation, it makes sense to be agnostic about a style-box change.

    However, Morningstar analysts will tend to be more critical if a fund's style-box shift truly signals that a fund is departing from an approach that has served it well in the past. If a fund changes style boxes because it has grown too large or because the manager appears to be chasing performance, that can and should prompt further scrutiny. For example,  Fidelity Low-Priced Stock (FLPSX), which once landed in Morningstar's small-value square, increasingly focused on midsize and larger companies as assets piled up. The fund remained a good investment--and still does. But Morningstar analysts urged Fidelity to close it so manager Joel Tillinghast could continue to make room for the small fry that had fueled the fund's returns earlier in its life.

  • Allows the choice: style-specific or free-wheeling?
    Morningstar has no standing predilection for style-specific funds versus offerings with more flexible mandates. We can name strong-performing examples of both types and don't believe one will deliver better returns than the other.

    For example,  Turner Midcap Growth (TMGFX), a focused play on its namesake sector, has long been one of our Analyst Picks. But so has  Vanguard Primecap (VPMCX), a freer-wheeling fund whose holdings typically include both growth and value names in a variety of capitalization sizes.

    We've seen investors succeed--and fail--by buying only style-specific funds, by buying more free-wheeling funds, or combining the two different types.

    Owning All the Squares Is Overkill
    Even though the style box can be an effective tool for ensuring that a portfolio is well diversified, investors can take a good thing too far. It's simply unnecessary to buy a fund from every square of the equity or fixed-income style box.

    Investors can have difficulty monitoring so many fund holdings, for one thing. Plus, most funds tend to have holdings that land in a few different squares of the style box. The holdings of  Fairholme Fund (FAIRX), for example, land in six of the nine squares of the style box. The Ownership Zone helps investors see a fund's real investment universe.

    Finally, one of the big risks of owning too many funds is that investors could end up with a portfolio that looks and behaves a lot like a broad-market index fund but costs a lot more than a pure index vehicle.

    Takeaways
    As we've noted, Morningstar isn't trying to police funds' investment styles. Good managers can and do move around the style box, and that's fine with us as long as such shifts are driven by where a manager is spotting opportunities rather than by performance-chasing or asset bloat. Rather than using the style box to "box managers in," the tool is most useful as a descriptor: to tell how a fund is investing, how it's performing, and how it fits within a diversified investment plan.

     

Christine Benz does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.