Morningstar's Janet Yang explains what the new classification system means for Vanguard Wellington, Dodge & Cox Balanced, the Fidelity Asset Manager series, and more.
Christine Benz: Hi, I'm Christine Benz for Morningstar.com. Morningstar is rolling out a new classification system for funds that combine both stocks and bonds. Joining me to discuss the new system is Janet Yang. She heads up our multiasset research at Morningstar.
Janet, thank you so much for being here.
Janet Yang: Thanks for having me, Christine.
Benz: So, Janet, these are funds that combine stocks and bonds together into a single portfolio. Under the old system we had a conservative, moderate, and aggressive allocation category. What's the new system going to look like?
Yang: Yeah. So, the new system is going from basically the three-bucket system to a five-bucket system. And we're changing the names a little bit. So, before you had, like you said, the conservative, moderate, and aggressive. So, with those--that three-bucket system we're going with a name change to asset allocation, equity, 30%-50%, 50%-70%, so basically you see the equity allocation within the name. I kind of like that because who really knows what "aggressive" or what "moderate" means?
Benz: Right. A little less guesswork in terms of figuring out what's in a portfolio.
Yang: Exactly.
Benz: So, some categories that do combine both stocks and bonds won't be affected by this change. So, you point out that the tactical asset allocation group, the world-allocation group, and all of the various target-date categories will be unaffected.
Yang: That's right. So, tactical, world, target-date, those will stay the same.
Benz: OK. So, I'd like to kind of unpack the why behind the change in classification system. What were the key factors? You mentioned that it's just a little more descriptive with the new system. Are there any other motivators, or do you think that it will just work better for some types of funds than perhaps the old system did?
Yang: Yeah, I think it's a little of everything. When you put together categories, I think it's a little bit of art and a little bit of science. When we're thinking about categories, we want the categories to be useful to investors. We want them to be relevant and kind of reflect the reality of what investors are choosing from. So, if we look at kind of our research in the past few months, we decided that looking at the allocation categories it just makes more sense to have a little bit more nuance in our categories. In the past, the three-category system worked, but now asset managers are kind of rolling out these target-risk series, for example, that aren't just a three-fund system. Sometimes they have five, six, seven, even nine funds within one series.
Benz: With different gradations of equity to bond exposure.
Yang: Exactly. Yes.
Benz: So, I know the Fidelity Asset Manager series you say is a really good example of a series that will be better suited by the new classification system.
Yang: Right. I think that's a good example. The Fidelity Asset Manager series, they have seven funds in total. So, under the old category system, they had like three funds in conservative, three funds in moderate, and for investors I think that probably wasn't super-intuitive to them, how to pick within those categories. So, now, they will just be spread out more and you'll just see a little bit more nuance in the performance.
Benz: And you say it will also suit some funds that in the past had been just kind of outliers in their category and there is a John Hancock fund that you think is a good example of a fund that didn't fit well within our old classification scheme?
Yang: Right. So, we found actually with a lot of these target-risk series the most aggressive fund in the series often ended up in maybe a large-cap category.
Benz: So, it was a pure equity category?
Yang: Yeah, exactly. And the John Hancock Lifestyle funds are an example of that. So, we found about a dozen funds that are part of target-risk series that will actually be moving from like a pure equity category like the large blend category into these new allocation categories.
Benz: You mentioned for a lot of funds, especially maybe the sort of 60%-40% funds, that this new classification system probably won't mean big changes for them, and you throw out Vanguard Wellington as maybe a good example of a fund where the new classification system for investors in the fund is going to be kind of a nonevent.
Yang: Right. So, we are adding the two categories. We're renaming the categories. But in reality, for example, the moderate allocation category essentially still exists. Before it was 50%-70% equity, and now the category is just renamed to the asset allocation equity 50%-70% category. So, the constituents are completely the same. A Gold-rated fund like Vanguard Wellington, which is about 65%-35%, so kind of your normal balanced fund, will stay there. So, its star rating kind of will probably stay the same. Its peer group stays the same, and from that standpoint, no change.
Benz: You note though that some funds, especially those with maybe a few more changes in their asset allocations from portfolio to portfolio may in fact see some jumping around among these different categories. Let's talk about a fund that is maybe an example of an allocation fund that might bounce around a little bit going forward.
Yang: Yeah. So, Dodge & Cox Balanced, it's not your typical balanced fund. It doesn't stick to 60%/40%. In fact, they can move anywhere from 25% equity to 75% equity. So, before it could jump around those three categories. At this point, it can go into conceivably any of four categories given that kind of range that they're working within.
Benz: You alluded to this already, but let's discuss the interplay between a new categorization system and percentile rankings within a category as well as star ratings. I think sometimes investors don't realize that a change in category can affect its percentile rankings as well as a fund's star rating.
Yang: Yeah. That's right. So, when we look at these category changes, we definitely want to look at kind of a before and after to see how the star ratings change because we want to make sure that our star ratings still kind of are conveying the right message. So, when we looked at the before and after, the new category changes actually result in about 15% of funds will see a star rating change. Of that 15% only I think less than 1% will see more than a 2-star change. So, to put maybe that 15% in context, basically in any given month our star ratings update, and a good or a bad month usually results in about 10% of funds seeing their star [ratings] change. So, 15% we thought was pretty good given kind of the change in categories.
Benz: And the percentile rankings are also calculated on a per-category basis. So investors might see some changes, perhaps modest in that realm as well, right?
Yang: That's right. So, I mean, the funds in the moderate-allocation category, in the old moderate-allocation category, for example, those won't change because the categories are still the same. But definitely, on the edges you will see more ranking changes.
Benz: So that former pure equity fund moving into one of these new allocation categories might look better or worse depending on the market environment?
Yang: Right, exactly.
Benz: OK. Janet, thank you so much for being here to discuss the new system with us.
Yang: Thanks for having me.
Benz: Thanks for watching. I'm Christine Benz for Morningstar.com.
