A Quick Tour of Morningstar's New Fund Categories

On Tuesday, Morningstar rolled out two new categories, eliminated one, and introduced an additional broad asset class classification. The mutual fund landscape is always changing, so we try to keep a lookout for the most relevant peer groupings. Our broader objective is to help investors put returns into context and sort through the large and ever-expanding universe of funds.

The new global real estate and currency categories will also help make funds' Morningstar Ratings more meaningful. For example, funds with a global focus have had an advantage over ones that invest solely in the United States. The global-leaning funds benefited from currency gains as well as the strength in select local real estate markets overseas. As a result, Morningstar Ratings in the real estate category were favoring the global varieties. Likewise, currency funds are a whole different animal than funds in their old world-bond peer group, and their returns reflected the differences. We're not assigning star ratings to funds in the new currency category because the wide variety of strategies nullifies the value in such a comparison, but removing them from the world-bond category will help keep those ratings more precise. Overall, the two new groupings will make it easier to separate winners and losers in the new categories as well as in the categories they vacated.

New Category: Global Real Estate
Global-bound real estate funds have been all the rage in recent years, and fund companies haven't missed the chance to jump in. More than 35 real estate offerings--nearly all with a global or international focus--have launched since 2005. Our new global real estate category is an outgrowth of our more general real estate category. We split the funds into two groups because the performance drivers of the domestically oriented funds and their more global-reaching siblings is truly distinct, and it is time to unmuddy the waters. To be in the new category, funds must invest at least 40% of their portfolios in foreign securities. The others will stay put in the original grouping.

There are some compelling options in the new global real estate category, but it's also home to several new, unproven, and expensive funds. The Cohen & Steers team has several interesting offerings such as  Cohen & Steers International Realty (IRFAX). We like the firm's approach to real estate and appreciate the team's experienced investing in the sector.

Although we decided to make the split for real estate, dividing every sector between global and domestic funds isn't appropriate. Global real estate is different from global health care, for example, because real estate truly is dependent on the local market whereas drug companies compete worldwide.

New Category: Currency
Until 2005, only one mutual fund--Franklin Templeton Hard Currency --had currency as its sole focus. And then the floodgates burst open and the Franklin fund received company, lots of it. By the end of June 2008, there were eight mutual funds and 26 ETFs offering some shape or form of currency exposure. Some are direct (and levered up) bets for or against the dollar while others give investors a way to own other currencies or a basket.

Our decision to create a currency category should not be considered a blanket endorsement of this type of fund, however. Most of the funds are new, unproven, and expensive. Moreover, most of them invite short-term speculation on currency fluctuations, which we think is a dangerous and unprofitable game to play.

Say Goodbye to the Florida Municipal Bond Category
So goes the tax advantage and so goes the need for a special category. Florida repealed the state's intangibles tax at the start of 2007, effectively negating the tax advantages of all Florida-specific muni offerings. Many fund companies, including Fidelity and T. Rowe Price, have already merged their Florida funds into more-diversified national funds. With the state tax advantage gone and most of the fund's disappearing, we decided to fold the remaining funds into our broader single-state municipal categories.

Alternative Funds Now Get Special Treatment
Previously, all of the Morningstar categories fell under one of the following five broad asset classes: domestic stock, international stock, taxable bond, municipal bond, and balanced. We decided to create a sixth broad asset class to house categories that show little to no correlation with more traditional stocks and bonds. Those categories were previously sprinkled throughout the other broad classifications but didn't look or act like anything around them. We think the alternative classification is more appropriate for currency, long-short, precious metals, and bear market funds.