A Look at Our Two New International Categories

From time to time, Morningstar creates new categories for mutual funds and investment portfolios. We'd rather not. Our objective is to make it easier for investors to make appropriate investment decisions, and that task would be simpler if they had just a few types of funds to evaluate.

But over the years, fund companies have added more and more variety to their menus, and many of the new options don't look or behave like the funds populating the existing categories. So, we have been faced with a choice: either leave new types of funds in categories where they don't fit well, making rankings and other statistics for those groups less useful as a result, or create new categories that have more logic and consistency to their membership.

The latter option is preferable. For that reason, on May 1 two new Morningstar international-fund categories appeared on the scene: foreign small/mid-blend and India equity.

Why Foreign Small/Mid-Blend?
On the domestic-stock side, Morningstar has long had separate categories representing all nine areas of the Morningstar Style Box, from large value to small growth. Not so for international equities. The reason was the scarcity of funds below the large-cap level. In order for a category's statistics and rankings to have meaning, the group must have some heft. Therefore, we like to see at least 20 or so funds before creating a new group. When we created the foreign-stock categories in 2003, there weren't enough funds in existence to adequately populate separate categories for all six boxes below the large-cap row. So, we combined small-cap and mid-cap funds into one group labeled small/mid, and we assigned them to either the value or growth side. Thus, we had just two style-box categories for international funds below the large-cap row.

That was reasonable given the landscape at the time, but it wasn't an ideal solution. Funds with portfolios that consistently landed in blend territory sat uncomfortably in a value or growth group. We were waiting for a time when enough such funds existed for them to merit a category of their own, without decimating either of the remaining two foreign small/mid groups. That time has arrived.

Details of the Group
The new foreign small/mid-blend category has about two dozen members on the open-end side alone, not including multiple share classes, along with nine exchange-traded funds. (The number is approximate because it can vary depending on whether one considers very similar portfolios from the same firm as distinct funds or simply as alternate share classes.) Now funds such as Vanguard International Explorer (VINEX), whose portfolio has consistently landed in blend territory for nearly 10 years, won't have to be forced into either a value or growth category.

Among the crowd in this new group are a few funds that knowledgeable observers might be surprised to see. The managers of Oakmark International Small Cap (OAKEX) and First Eagle Overseas (SGOVX), for example, are known as value-oriented investors. But their funds end up in the new blend group because on average their portfolios have landed squarely in the blend style box over the past three years or longer.

It's worth noting that category assignments are not set in stone. If these or other funds start to land consistently in either the value or growth boxes, or cross definitively and consistently into large-cap territory (a move some are flirting with), then at some point in the future they could be shifted out of this category into a more appropriate group.

Onward to India
A similar story explains the creation of the India-equity category. A few India funds have existed for years, but there weren't enough to merit a category of their own. That changed in recent years. Now there are 11 open-end funds, 10 ETFs, and three closed-end funds that focus on Indian equities.

Putting them into their own group serves three helpful purposes for investors. First, it eases the task of making comparisons among them, for they are now being ranked solely against each other rather than against funds that could invest across most of Asia. Second, their former category, Pacific/Asia ex-Japan, now provides more useful information as well, for the same reason. What was once a very heterogenous category has become much easier to navigate, with the subtraction of China-focused funds into their own category in October 2010 and now the migration of the India funds. Third, the change simply makes it easier for people looking for India funds to find them.

It is important to note that the creation of the India-equity group is by no means an endorsement of them and should not be taken as a buy signal. As noted above, only the number of funds, not their quality (or an evaluation of the appeal of India's market), explains the appearance of the category at this time. In fact, if anything, investors should be wary when a new category comes out. That typically means many new funds of that type have been launched fairly recently--and fund companies tend to take such actions when markets are popular and hot, a trend that can't go on indefinitely. The unimpressive performance of the China-region category after its creation should provide a warning.

Not Perfect, but Better
Although the international-stock categories have been improved, they're still not perfect. For example, though much more homogeneous than it used to be, the Pacific/Asia ex-Japan group still has a few funds devoted to Korea or Australia rather than to the entire region. That said, the creation of the new categories should make it much easier for investors interested in supplementary international funds to find and evaluate the choices at hand.