Morningstar Introduces 11 New Fund Categories

Today Morningstar is rolling out 11 new categories and eliminating one. The new categories make it easier for you to find the fund you're looking for and identify the most skilled managers more quickly.

Our categories, which we use to group funds for purposes of ratings and relative performance, are based on the underlying holdings in a fund's portfolio over the trailing three years. The new categories are the result of work done on the Morningstar Rating for funds in 2002. You'll recall we improved our star-rating methodology last summer by focusing more narrowly on categories rather than broad asset classes.

Because of that increased emphasis, we systematically reviewed our categories--using some basic guidelines--to be sure that they accurately reflected the mutual fund marketplace. For example, we required the Morningstar categories to be clearly defined and easily measured based on funds' portfolio holdings. In addition, at least 20 funds must exhibit the characteristics of a category, as evidence that they are following an established strategy.

During the review, we determined that nine strategies deserved their own additional categories. Furthermore, we decided to split one of our largest categories into two. The new categories don't make it easier or harder for funds to earn 5 stars. We'll continue to award 5 stars to the top 10% of portfolios in each category and 1 star to the bottom 10%. Thus, the number of 5-star funds is virtually unchanged.

Splitting Domestic Hybrid Down the Middle
In recent years, fund companies have gotten much more specific about targeting various asset mixes. They used to just have one balanced fund for investors who wanted a combination of bonds and stocks. Now, many have an array of mixes. Vanguard alone had nine different funds in our domestic-hybrid category, and the group itself had grown to 398 funds, which made it our third-largest category. It encompassed funds with anywhere between 20% and 70% of assets in equities. Thus, asset allocation usually played a bigger role in year-to-year relative performance rankings than manager skill.

For instance, three years into the bear market, asset mix had a noticeable impact on hybrid funds' star ratings and relative performance. The average rating for funds with more than 50% in stocks was nearly a whole star lower than that for bond-heavy hybrid funds. The gap was more than a whole star between funds with more than 50% in stocks and those with less than 40% in stocks.

We thought it was time to split the group into two so that strong relative performance and star ratings were not dominated by asset mix. So within the domestic-hybrid category, funds with 20% to 50% in equities and 50% or more in fixed income and cash are now classified as conservative allocation, and funds with more than 50% in equities are now labeled moderate allocation.

Many of the category's largest funds land in the new moderate allocation category.  Vanguard Wellington (VWELX),  Fidelity Puritan (FPURX), and  Dodge & Cox Balanced (DODBX) have roughly 65% in equities and 35% in fixed income. However, some other big funds land in the new conservative allocation category, including  Franklin Income (FKINX), which has more than half its assets in bonds and cash.  Vanguard Wellesley Income (VWINX) has an even more cautious asset mix, featuring just 35% of assets in stocks, and it's also in conservative allocation.

New State-Specific Muni Categories
We created six new state-specific municipal-bond fund categories. The holdings of these funds are exclusive to their states and therefore fit our guidelines of distinct, measurable portfolios. The new categories allow investors to quickly find the funds they want, because they can go right to the category that covers their state.

Further, the new categories make it easier to figure out which funds have done the best on a risk-adjusted basis because managers are now compared only against rivals with a similar investment universe. For example, Nuveen Massachusetts Municipal Bond (NMAAX) ranks in the top third against a broad group of single-state muni funds for the trailing three-year period, but on closer inspection, it's not quite as impressive. Compared with other funds from the state, the fund is below average.

Our new categories cover Florida, Pennsylvania, Massachusetts, New Jersey, Ohio, and Minnesota.

New York, California, and Single-State Categories
The New York, California, and single-state muni categories have had a slight change to their definitions and names. State-specific municipal-bond funds are most appropriate for investors who reside in that state and can take advantage of the state tax benefits. Therefore, it is most useful if these funds are grouped by state rather than by duration (short, intermediate, and long). So, all single-state municipal-bond funds have been removed from the muni short category, which contained both national-focused and state-focused funds. The single-state, short-duration funds were either assigned to a general single-state category or to a state-specific category.

We renamed single-state categories that now include both intermediate and short-duration single-state funds. Muni single state intermediate is now muni single state intermediate/short, muni New York intermediate has been changed to muni New York intermediate/short, and muni California intermediate is now muni California intermediate/short. Because single-state funds have been removed from the muni short category, that category was renamed muni national short.

We also changed the names of two categories for consistency across the board. International hybrid has been changed to world allocation, and international bond has been changed to world bond.

Muni High Yield
The muni high-yield strategy has gradually grown to a size that merits carving it out of the muni national category. Virtually every big fund company now has a national high-yield fund that invests in lower-quality bonds to complement their high-quality national fund. The largest high-yield muni fund is the $5 billion  Franklin High Yield Tax-Free Income Fund (FRHIX).

The muni high-yield category includes any fund with a majority of assets in BBB-rated bonds or lower. For this purpose, we included nonrated debt in our tally of bonds that are BBB or lower. In the taxable-bond market, BB is the borderline for high-yield, but in municipal bonds, the line is drawn at BBB. Although BBB munis might have a slightly lower default risk than BB-rated taxable bonds, they have greater liquidity risk because they are thinly traded. Thus, a BBB rated muni bond still packs plenty of risk.

When bunched in with higher-quality funds, a high-yield muni fund's relative performance generally reflected how high-yield munis were performing relative to high-quality munis rather than anything specific to the fund. Indeed, high-yield muni funds are significantly riskier than the typical muni fund and are therefore more of a niche holding, whereas high-quality munis can be core holdings. Thus, the new muni high-yield category allows investors to make better comparisons of high-yield muni managers while preventing those seeking high-quality funds from making a big mistake.

Bank-Loan Funds
Funds with a majority of their assets in floating-rate bank loans are now grouped in this new category. The story for bank-loan funds is somewhat similar to that of muni high yield. These funds are growing in popularity thanks to the sizable income stream they throw off. However, they are clearly much riskier than the ultrashort-bond funds they had been lumped in with. They carry more credit and liquidity risk and, therefore, should not be used as cash substitutes the way some investors use ultrashort-bond funds. In fact, liquidity is so tight that some funds in the category only allow redemptions quarterly. The $2 billion  Van Kampen Prime Rate Income (XPRTX) is the group's largest.

Bear-Market Funds
We created a new category for bear-market funds, and it is a special case in many regards. The bear-market funds category doesn't yet have 20 funds, but we created it because funds that use short-selling techniques serve a different purpose than those that are covered by our current categories.

The most prominent funds in this group, such as  Rydex Ursa (RYURX), target the inverse of their benchmark's returns. By taking these funds out of the nine categories based on the equity style box, those categories' average returns and relative rankings now reflect a typical category fund. In addition, this new category makes it much easier for investors to find bear-market funds because it was tough to figure out which category they were in. We're limiting this group to funds that are purely short positions.

Market-neutral and long-short funds are now in conservative and moderate allocation, because those categories are closest to these funds' risk/reward profile. Down the line, we'd consider creating special categories for them if they passed the 20 mark.

Bear-market funds do not receive a star rating because the ratings wouldn't have any meaning. The star rating is premised on the idea that funds are judged against funds with similar portfolio characteristics and risk/reward profiles, but that's not true of bear-market funds, which short a range of asset classes. A star rating would merely tell you which asset class fared the worst--thus it would probably be closer to a contrary indicator than a useful screen in finding good bear-market funds.

Conclusion
Most funds did not change categories, but for those that did, the new categories better capture their investment universes. In addition, they group funds with similar risk/reward profiles more precisely. For investors, this makes our star ratings and relative-performance figures more helpful in identifying the most attractive funds.

A version of this article appeared on May 5, 2003.