2 Divergent Funds in a New Morningstar Category

Wiley Green: Last year, Morningstar rebuilt the categorization framework for asset-allocation funds. The previous system consisted of three main categories, and the new system is an expanded version, made up of five categories distinctly labeled by their equity targets. One reason the categories were rebuilt was to better capture target-risk fund suites. Some of the most "aggressive" allocation products were incorrectly falling into the large-blend or large-growth style box category. Now that the dust has settled on the new framework, let's take a closer look at the new members of the Allocation 85%+ Equity category.

The majority of constituents are indeed aggressive allocation funds. Take Bronze-rated MFS Aggressive Growth Allocation as a prototype. The most aggressive fund in the four-fund MFS Allocation suite currently holds more than 90% stocks, with a sizable percentage in non-U.S. securities. It doesn't deviate much from the asset-allocation target, which is set by MFS using mean-variance optimization and implemented using a handful of the firm's best active funds.

Not all peers look like the prototype, though. Bronze-rated Franklin Mutual Shares is the largest fund in the category, and, unlike many peers, stands out for its fundamentally driven security selection process. The storied team of value investors looks for great deals, and will dabble in merger arbitrage and distressed debt as a natural extension of their process. The end result is a portfolio with stakes in bonds and non-U.S. stocks that does meet the definition of the 85%+ Equity category, despite the complete divergence in portfolio construction. As a result of this fundamental difference, Mutual Shares lands in the value section of the style box--one of just three funds in the category to do so.

The bottom line? The new categories fixed some problems, but investors still can't assume two funds in a given category are perfect substitutes without doing a little homework.