When Fund Asset Allocations Run Wild

Question: I find the Morningstar.com Asset Allocation chart for my bond fund to be confusing, in particular the bars showing negative exposure to some asset classes. Can you help me understand how this works?

Answer: The Asset Allocation chart you mention, which is found under the Portfolio tab on Morningstar.com's fund pages, is usually a straightforward affair. That's because many, if not most, funds use a straightforward investment approach: They hold stocks, bonds, or other investment types their managers think will appreciate in value or that fit into their investing approach in some other way. However, for funds that use more complex strategies--such as those holding both long and short positions or that use derivatives--a more complex representation is required.

We'll take a closer look at how the chart deals with these strategies in a moment, but first and foremost it's important to understand that the asset-allocation data set you'll find on Morningstar.com is designed to reflect a fund's exposure to various asset classes. How the fund gains exposure to these classes can vary, but the ultimate goal is to help investors understand how the fund is positioned and the role different asset types play in its performance.

Example: Long/Short Equity
One good example of an unconventional investment approach and how Morningstar deals with its asset allocation is long/short equity funds. To review, a long strategy is one in which a stock is purchased with the expectation that its value will increase so that it later may be sold at a profit. A short strategy is the reverse: A stock is first sold (a fund may need to borrow shares to do this) with the expectation that its price will decline, at which point the fund can purchase shares at the lower price to replace those that were sold earlier, thus realizing a profit in the difference between the shares' sale and purchase prices.

Some funds employ both these approaches in the hope of picking the right stocks that will gain in value (long positions) and the right ones that will lose value (short positions). Funds that hold sizable stakes in both long and short stock positions are called long/short equity funds and are part of Morningstar's alternative category. To illustrate how Morningstar's fund pages address long and short positions in a fund's portfolio, let's look at the Asset Allocation section for one of these funds:  Wasatch Long/Short Investor .

The first thing you may notice is that the fund's asset allocation is not represented by a pie chart, as it is with long-only equity funds. Second, you'll note that the blue bar representing the fund's U.S. stock holdings extends into negative territory. The bar's position corresponds to the numbers in the table to the right, which show that 56.75% of the fund's net assets are invested in U.S stocks. However, within that asset class the fund invests the equivalent of 12.41% of its assets in short positions and 69.16% in long positions. Subtract the short stake from the long stake and you get the net amount. 

You may wonder why the long and short positions aren't added together to represent the total percentage of fund assets invested (one way or another) in U.S. stocks. But remember that short positions don't represent stocks the fund actually owns but rather stocks that it must replace from earlier sales. In other words, for our example above, the fund essentially owes, or must replace, shares equal to 12.41% of its assets. It's also worth noting that proceeds from short sales are held in cash, contributing to this fund's sizable cash stake of more than 30%.

Second Example: Funds That Use Derivatives
Reporting asset-allocation data gets even trickier for funds that use derivatives, which provide a way to gain exposure to a security without owning the security outright. A bond fund might use derivatives to hedge interest-rate risk, or a commodity fund might use them to provide exposure to a type of commodity without actually buying and storing the physical asset. (You can learn more about how and why funds use derivatives in this Short Answer article).

Morningstar treats derivatives as exposure to the underlying asset. For example, a fund that holds 10% of its assets in U.S. Treasury futures will have an asset allocation that looks as though it actually owns the Treasuries even though technically it hasn't taken delivery of them.

Futures allow the owner of a contract to lock in a future purchase of an asset at a price that is determined today. Typically only a small percentage of the security's purchase price must be paid initially, with the remainder due upon delivery. While the futures will be represented in the fund's Asset Allocation chart as though the underlying security were in the fund's portfolio, an offsetting cash position is also included to represent cash that has been committed to buying the security at some point in the future. For long futures positions, the offsetting cash position is treated as negative cash exposure whereas for short futures positions it is treated as positive cash exposure because it represents cash that is owed to the fund from the sale of the contract.

Let's look at an example of a bond fund that uses derivatives and how its asset allocation is presented. Below is the Asset Allocation chart for  Federated Total Return Bond (TLRAX), a fund owning four Treasury futures, including one large long position and three much smaller short positions. The long futures contract is counted as part of the fund's total long bond exposure, helping push it to 147.1% of the fund's total assets. Meanwhile, the fund's short futures positions push its negative (short) bond exposure to 21.84% of fund assets. The result is a net bond exposure of 125.26%. The fund also has a 29.16% positive cash exposure and 54.84% negative cash exposure (remember that cash offsets and futures appear on opposite sides of the ledger). This results in a net cash exposure of negative 25.68%. The end result is a portfolio with a net 125.26% bond exposure that is offset (primarily) by a negative 25.68% net cash exposure.

Derivatives and Asset Classes
As described in Morningstar's "Shorts and Derivatives in Portfolio Statistics" methodology document, derivatives related to stocks--including futures and options on individual stocks and stock indexes--are counted as Stock in the Asset Allocation table. Those dealing with bonds--including futures and options on bonds and long-term interest rates, and most swaps--fall under Bond. Futures and options on short-term interest rates and currencies, as well as cash offsets for other derivatives, fall under Cash. Futures and options related to commodities, the weather, and volatility are counted as Other.

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