What, Exactly, Is a Flexible Fund?

Another Perspective Last week's column on flexible-stock funds raised a question from Morningstar's Mike Breen. In that column, I defined flexibility as does pretty much anybody else who looks at the issue: in relative terms. A flexible-stock fund is one that varies, relative to the current stock market, in the size and/or style of the securities that it owns. It may sometimes hold companies that on average are larger than what other funds hold, or smaller, and/or may sometimes own companies that on average sell at lower price multiples (that is, value stocks), and sometimes not.

In theory, therefore, a fund could own a portfolio that has fixed attributes--say, a median stock market capitalization that always runs about $10 billion, and a price/book ratio that hovers near 2--and yet Morningstar would score that fund as "flexible," rather than as "style consistent."

Mike wondered if that is accurate. Should fund researchers not define flexibility by using absolute rather than relative measures? To do so would flip the results. By his reasoning, the portfolio that maintains a steady market cap of $10 billion and average price/book ratio of 2.0 is style-consistent, while those that bounce around are flexible.

He wrote:

I am a fund. I report the same portfolio data below to Morningstar every single month for 10 straight years, but I move all over Hell's Half Acre in the Morningstar Style Box because the box is entirely relative and everyone else's data changes every month: Did I constantly change my style? Put another way. I am 6'2". I go to a convention of basketball players, and I am the shortest person. But when I traveled around in Thailand, I was the tallest: Did my height change?

Perhaps you should be a fund, Mike. Then you would not ask persnickety questions. (Then again, anybody who sends an idea for a column topic is all right with me.)

Let's consider two paths for implementing Mike's suggestion. One way is to measure a manager's absolute approach by using snapshots. The second is through moving averages. That is, we could look at the stock market capitalization and style of a fund's holdings quarter by quarter to see if those statistics move. Or we could smooth the function by using the averages of several portfolios, over time.

Surely, Mike would grant that the first approach fails. Consider an index fund that owns the Wilshire 5000. The median stock market capitalization of its portfolio is $40 billion and the price/book ratio is 2.3. (Those are indeed the current statistics for

something

to illustrate the example.)

The stock market suffers a sudden jolt and drops 20% in price over the next month, even as book values remain intact. The index fund's market capitalization declines to $32 billion, and its price/book ratio becomes 1.8. Voila! The absolute-snapshot measure reports that the index fund is flexible; it has moved from being large blend to large value and has also moved south toward the mid-cap region.

That doesn't work. We can't call the index flexible because it holds exactly the same securities as before, while the market prices have fluctuated.

(The example reminds me of a certain Morningstar CEO, whose name shall be withheld for this author's protection, who once held stock-analysis training sessions for aspiring Morningstar analysts. The troops would research a stock, going through the filings and financial statements, and would present their recommendation: Buy, Hold, or Sell? Inevitably, after a protracted discussion, the CEO would issue his conclusion: Wait until the stock price declined so that it fell below the company's book value.

That his own company's stock has never remotely traded near book value has always amused me ... but also pleased me, as it is my largest portfolio holding--which, yes, is a grievous financial-planning sin. The barber has a terrible haircut.)

The absolute approach makes much more sense when using rolling averages. The market's bumps will no longer disrupt the calculation, nor will changes in book value or earnings prospects caused by the economic cycle. Although even a 10-year period is prone to the choice of starting and ending dates--for example, some 10-year periods will contain but one recession, while others will have more--such inconsistencies are far, far smaller than when taking snapshots.

This sort of absolute benchmark, in fact, is what the famed Shiller CAPE ratio attempts. It divides a company's current stock price by the average of its reported earnings over the past 10 years, with the earnings adjusted for inflation. CAPE devotees then aggregate those ratios for the entire stock market so that they can determine if the current marketplace seems to be dear, cheap, or something in between. The center line for this assessment is the ratio's very long-term average, which extends for more than a century.

One could judge a fund's flexibility similarly. We could determine the absolute cutoffs for size and style by finding the market's rolling 10-year averages, then call funds flexible if they bounce around those averages and style consistent if they do not.

Unfortunately, doing so would encounter the same problems that have bedeviled users of the Shiller CAPE ratio. Conditions change. Accounting standards evolve, requiring either adjustments to the calculations of corporate earnings or the acceptance of those inaccuracies. Worse, inflation expectations and interest-rate regimes are not fixed. A price/earnings ratio that looked high during the inflationary '70s might be appealingly low during this millennium, when bond yields are punk and offer little competition. The predictive value of the CAPE ratio has suffered mightily because of such issues.

In short, the pursuit of the absolute is a perilous task. The approach sounded reasonable as Mike stated it, but his analogy of a 6'2" man traveling to lands where people are of different heights is not, I think, the correct one. I would frame the matter differently. Funds occupy a globe that is spinning. A fund that frantically races against the spin so that it always occupies the same place in space is a fund that is moving. That is a flexible fund. In contrast, a fund that lets itself be pulled by the spin is style consistent. The fund itself does not move; it is everything else that changes.

(Note: Mike knew much of this, if not all, when posing his question. He advocates well for the devil.)

John Rekenthaler has been researching the fund industry since 1988. He is now a columnist for Morningstar.com and a member of Morningstar's investment research department. John is quick to point out that while Morningstar typically agrees with the views of the Rekenthaler Report, his views are his own.