Growing Fund Choices Spur 4 New Categories

In yesterday's Fund Spy, Janet Yang and Benjamin Alpert elucidated the reasons behind the most recent modifications to the Morningstar Categories for allocation funds and the impact of those changes. Today, we focus on the rollout of new categories across the equity, fixed-income, and alternatives asset classes.

The four new categories are infrastructure (within the equity asset class), emerging-markets local currency (within fixed income), and option-writing and long-short credit (both within alternatives). The rationale and details behind each new category are spelled out below. We don't make category introductions or category changes lightly or quickly; just because there's growth in a product type doesn't mean we'll automatically roll out a new category. But sometimes, the expansion of new product subtypes within an asset grouping can result in increasing heterogeneity within a category, so creating new categories allows us to maintain consistency across funds within a Morningstar Category.

Several factors help determine our decision to launch a new category. First, there must be a sufficient number of funds following the strategy to ensure that the strategy type is more than a fad and that there is a robust peer group. Second, we must be able to observe performance behavior that binds the new group of funds and differentiates them from their previous category assignment. Finally, we need a tangible hook--whether from portfolio data, performance characteristics, or prospectus language--that enables us to identify the fund's strategy as consistent with the new category. Our preference is to use portfolio data, but for many alternatives and fixed-income funds, the portfolio alone doesn't provide enough information. We won't assign a fund to a category just because a fund company tells us they want to be in it, but we do have an appeals process that allows funds to make their case.

General Questions Why does Morningstar change its category system? We strive to keep our categories relevant for investors and reflect the realities of the investments being used. We incorporate our internal research, academic research, industry trends, and stakeholder feedback into our decision process. Since categories were introduced around 30 years ago, we've regularly reviewed our classifications to ensure the assignments provide meaningful insight for investors. We now perform this analysis annually. Currently, we have around 120 categories for the 10,000 registered mutual funds that we classify in the United States. When we first launched categories around 1988, there were only eight.

How do the category updates affect star ratings? Morningstar Ratings are relative to the category assigned for the month for which the rating was produced. Each month funds hit their three-year (or five- or 10-year) anniversary, or are merged or liquidated. Morningstar also monitors funds' portfolios and investment strategies to ensure that there hasn't been a change in the underlying strategy. About 15% of share classes--approximately 1,500 funds--saw a ratings change because of category reassignments. Of these changes, roughly 90% were a 1-star change.

Emerging-Markets Local-Currency Bond Questions Why is Morningstar creating an emerging-markets local-currency bond category? The menu of dedicated emerging-markets bond funds has noticeably expanded in the last decade. During that period, countries have increasingly issued debt denominated in their own currencies, improving liquidity and availability of bonds in these markets, and investors have simultaneously sought the diversification that emerging-markets bond funds offer. While the majority of emerging-markets bond funds exclusively hold hard currency (foreign debt denominated in the U.S. dollar) or hard currency with tactical currency flexibility along the edges of a portfolio, a burgeoning group invests primarily in local-currency debt.

Given the added volatility associated with currency fluctuations, performance of funds that invest in local-currency debt can at times diverge significantly from that of hard-currency funds. Over the trailing 10 years ended March 2016, the JPM GBI-EM Global Composite Index, which is local-currency denominated, has experienced 50% greater volatility than the JPM EMBI Global Index, which is hard-currency denominated. Currency choices significantly impact returns in the shorter term, as well. Consider rolling three-month correlations between the two indexes over the 10 years ended March 2016: 9% of the time, the returns weren't simply different, they were negatively correlated--meaning that returns moved in opposing directions. The correlation of the two indexes over the entire 10-year period was around 0.8.

What does this new choice in the emerging-markets bond category mean for investors? Of the roughly 100 emerging-markets bond funds, around 20 now inhabit a distinct local-currency category. Criteria include a minimum of 65% of assets invested in local-currency foreign bonds and a mandate to maintain exposure to currencies in emerging markets. Given that emerging-markets bond performance is significantly affected by the choice of hard- or local-currency denomination, the new category makes it easier for investors to consider funds that specialize in either relative to more-appropriate and distinct peer groups.

Infrastructure Category Questions Why is Morningstar creating an infrastructure category? Infrastructure-themed investing has grown more popular during the last decade, initially with pensions and endowments. During the last few years, infrastructure strategies have become accessible to retail investors via mutual funds and exchange-traded funds. Currently, there are about 30 funds in the new infrastructure equity category.

What types of firms do infrastructure funds invest in? Infrastructure funds primarily invest in energy, industrial, utilities, and telecom firms that hold long-duration assets that generate stable cash flows. Examples include toll road operators, pipeline firms, airports, cell tower owners, and electric and gas utilities.

What are the general traits of infrastructure funds? Prior to the creation of the infrastructure category, most of the funds were classified as world-stock funds. Typically, these funds have about a 30% to 50% allocation in U.S. stocks with the remainder invested in firms domiciled in the developed world. These funds, on average, tend to exhibit lower beta relative to the market.

Long-Short Credit Category Questions Why is Morningstar creating a long-short credit category? As the non-traditional-bond category has expanded, we have observed a growing subset of funds that largely take interest-rate risk out of the investing equation and instead focus on relative-value credit opportunities, using both long and short investing techniques. While other funds in the non-traditional-bond category, sometimes referred to as unconstrained bond funds, can and do invest in corporate credits, they also invest in many other bond sectors globally and may make significant changes to overall interest-rate exposure, including the ability to run a net short duration, as a primary tool. While there has been little performance difference during the past few years, academic research indicates that in different credit and interest-rate environments, these two groups will behave in different manners.

What are the key characteristics of long-short credit funds? Long-short credit funds generally have high exposure to corporate-credit cash bonds or to credit default swaps. Moreover, to end up in the alternative long-short credit category, they should have the ability to take short positions on credit (via individual bonds or CDS) and to show evidence that they have actually employed this capability. Finally, because managers of long-short credit funds intend to generate alpha primarily via security selection, they tend to hedge out interest-rate exposure, often by using interest-rate futures. Thus, long-short credit funds tend to have low duration, high credit exposure, and relatively steady moderate risk/moderate return profiles. Around 25 funds are part of the initial long-short credit peer group.

Option-Writing Category Questions Why is Morningstar creating an option-writing category? During the past several years, we've seen an increase in funds that use dedicated options strategies. These funds have been an uneasy fit for both long-only Morningstar Style Box categories, where they often had much lower betas than the rest of the category, and for long-short equity, as many options-based strategies do not include a protective or insurance element that investors would expect from a long-short equity fund. Moving options-based funds from long-only and long-short equity categories into their own category not only creates a natural home for this burgeoning group of funds but also helps create greater cohesion in the legacy categories.

What are the key features of funds in the option-writing category?

There are many different types of options strategies, and to some extent the new category will reflect that heterogeneity. As a baseline, funds in the category will use options as a central and consistent part of their investment strategy. Initially, funds assigned to this category will include, but are not limited to, put writing, covered-call writing, option spread, options-based hedged equity, and collar strategies. Approximately 35 funds initially land in the new category; the largest and best-known fund to move to the new category is

Benjamin Alpert, Patricia Oey, and Emory Zink contributed to this article.