Why Morningstar Lacks an All-Cap Fund Category

Mea Culpa
Morningstar lacks an all-cap category for U.S. stock funds, a decision that strikes many investors, advisors, and fund companies as strange at best and proof of Morningstar's ignorance at worst. It's a policy that has cost Morningstar significant goodwill over the past decade--to say nothing of money--with frustrated subscribers metaphorically tossing Morningstar's software against the wall and cursing the idiot who created Morningstar's fund categories.

I was that idiot. This article explains what I was thinking.

First, all-cap funds aren't something different; they are something already extant but with a new name. Many, if not most, equity funds can be called all-cap. Aside from the minority of funds that describe themselves by strict style names, such as large-cap value or small-cap growth, U.S. equity funds typically hold positions in a wide variety of company sizes. Indeed, one of the major reasons the Morningstar Style Box is divided into nine squares and not four is that the world's largest mutual fund at the time,  Fidelity Magellan (FMAGX), was spread across large, medium-sized, and small company stocks. It seemed wrong to put the fund in either a large-cap or a small-cap category.

Second, I couldn't figure out how to measure all-cap funds. Morningstar generally assigns funds to categories not by how the funds name or market themselves, but rather by how they invest. For each fund category, there are quantitative rules that govern which funds go into the category. An all-cap fund, for example, might be defined as a fund that invests primarily in U.S. stocks and has at least 20% in each of small, medium-sized, and large companies. But I found that no matter how I set the numbers, some all-cap funds would not qualify for the all-cap category, and a whole lot of funds that didn't call themselves all-cap would land in the category.

If investors look in a category called all cap, and some funds that have all cap in their names are not in it, while other funds that are not called all cap, that don't think of themselves as all cap, and that don't present themselves as all cap, do land in that category, well that's not good. It's worse than not good. It's a greater idiocy than not having that category at all.

Thus, if all-cap funds were to be grouped into a category, it would need to be done by looking at their names as opposed to their portfolios. That was not an appealing prospect. Morningstar is supposed to be cutting through fund marketing to get at what funds actually do, not assisting in fund-company marketing.

Third, since all-cap funds were nothing new, they didn't figure to perform any differently than existing funds. What would be the point in putting those funds in a new category, when they were well-described by the existing system? Yes, fund sponsors claimed that with extra freedom the funds' managers would deliver extra returns. (But they would say that, wouldn't they?) But since most stock-fund managers already enjoyed that very same freedom, it was a hollow promise. Sure enough, all-cap funds haven't been special. On Friday, I screened for U.S. stock funds with "All Cap" in their names. In aggregate, such funds placed in the 51st percentile relative to the fund categories to which they are assigned for the trailing three years, the 51st percentile for the trailing five years, and the 47th percentile for the trailing 10 years. Right smack in the middle.

Finally, the concept of an all-cap fund came from fund marketers, not investment managers. The proof is that while there were three dozen launches of all-cap funds, there wasn't to my knowledge a single launch of an all-style fund--that is, a fund with the freedom to roam not from large to small companies, but instead from value to growth companies. That was very puzzling from an investment perspective. There was no logical reason for all-cap to exist as a category when all-style did not. In fact, the argument may well be stronger for all style as a category than for all cap, because over the long term, the value effect is larger than the size effect. That is, value stocks outgain growth stocks by more than small-company stocks beat large-company stocks. So why have funds that only move along one axis, and the less important axis at that?

For those who made it this far, thanks for your patience. I did warn that this is an insider's column. I'll be more outside tomorrow, I promise.

John Rekenthaler has been researching the fund industry since 1988. He is now a columnist for Morningstar.com and a member of Morningstar's investment research department. John is quick to point out that while Morningstar typically agrees with the views of the Rekenthaler Report, his views are his own.