Are Your Core Holdings Really 'Core'?

Anyone who's ever built a house knows the importance of a strong foundation. No matter how sturdy the structure above it might be, if the foundation is weak, you could be looking at major problems down the road.

In investing, we refer to certain types of assets as core holdings: These are the bedrock of your portfolio, the foundation upon which you build a collection of holdings appropriate to your goals. Core holdings typically are lower in volatility than other investments and provide broad exposure to a large market segment. For example, you probably wouldn't want to look at an emerging-markets stock fund as a core holding because of the category's high degree of volatility. A large-cap domestic- or foreign-stock fund with broad exposure to developed markets is likely to provide more stability--if less potential for spectacular gains--than a fund made up of stocks whose performance is less predictable.

The same principle applies bond investing. High-yield bonds offer the potential for outsized gains but carry a higher risk profile than a vanilla short-term bond fund would, for example. This doesn't mean a high-yield bond fund has no place in your portfolio, of course. Such a fund can serve a complementary role, boosting returns and adding diversification by capturing parts of the market that your core bond holdings don't cover. But you wouldn't want to build your portfolio atop such a shaky foundation.  

To help investors determine which funds make good core holdings and which are better-suited for other purposes, Morningstar analysts assign ratings based on what they consider to be a fund's ideal role in a portfolio. Aside from Core, funds may be designated as Supporting Player or Specialty. Supporting Players are secondary holdings that serve as complements to the core holdings that make up the bulk of a portfolio, while Specialty funds are more speculative in nature and generally play a smaller role--for example, sector- and region-specific funds.

Where to Find Core Exposure
The large-blend, foreign large-blend, and intermediate-term bond categories are usually good starting points for investors in search of core exposure; the same goes for Morningstar's various allocation-fund categories. But not every fund that lands in a traditional core category is truly core-holding material. In some cases a fund's peculiarities--for example, the manager's unorthodox approach or the fund's high-risk bent--might make it better-suited as a supporting player.

To find some of these exceptions to the rule we used Morningstar's  Premium Fund Screener tool and searched for funds that Morningstar's fund analysts rate as Supporting Players even though they come from traditional core fund categories. We screened on analyst-rated funds in the large blend, foreign large-blend, and intermediate-term bond categories. Premium users can view the entire screen
 here, and below are examples from each of these three categories and why they carry a Supporting Player label rather than Core.

Large-Cap Blend
 Mairs & Power Growth (MPGFX)
For some investors, this fund might work as a core holding given its low volatility and multicap blend approach, but it also has some quirks that land it a borderline Supporting Player rating in our analysis. Manager Bill Frels and his team take home bias to heart, investing primarily in companies headquartered in or near the fund's home state of Minnesota, such as  3M (MMM) and  Target (TGT). The fund's geographic bias means it owns no energy stocks, which make up about 11% of the S&P 500.

Foreign Large-Cap Blend
 Longleaf Partners International (LLINX)  
Despite investing primarily in large companies in developed economies, this fund's deep-value philosophy and benchmark-agnostic approach could make it better-suited to a supporting role than as a lead player, particularly for international investors who are seeking broad foreign-stock exposure. The fund's managers look for companies selling at 60% or less of what they believe to be their true values. In early 2011, the fund held 21% of assets in Japan, resulting in a disastrous 20.3% loss in a year when the foreign large-blend category lost 14% on average. (Japan now makes up just 7.6% of the portfolio versus 16.8% for the category.) Only about 3% of the portfolio is invested in the United Kingdom versus more than 20% for the category average. The fund used to hedge all of its foreign currency stakes into the dollar and still might do some hedging on a case-by-case basis.

Intermediate Bond
 Vanguard Intermediate-Term Investment Grade Bond (VFICX)
Many funds in this category make for good core holdings, but not this one. Its heavy weighting of corporates and above-average risk rating make it better-suited in a supporting role. About 63% of its holdings are corporate bonds, more than double the category average. About two thirds of its portfolio's holdings are rated A or lower versus 42% for the category. It's a good fund for corporate-bond exposure, provided you augment it with holdings that emphasize other bond sectors, as well.

Portfolio data as of Dec. 31, 2011.