Understanding the Mutual Fund Style Box

A style box is a graphical representation of a mutual fund's characteristics. The financial services research provider Morningstar, Inc. popularized this tool by placing it alongside its well-known mutual fund ratings system, which ranks mutual funds by assigning them between one and five stars. As a result, many mutual fund investors have become familiar with the style box and its use as a tool for evaluating mutual funds.

At the same time, the style box is a tool with several other practical applications. Read on to find out how style boxes can be used to categorize mutual funds and individual securities and to help you understand money management and the asset allocation strategy of your portfolio. (Learn more in "Morningstar Lights the Way.")

The domestic equity style box is designed to assist in the evaluation of securities and is the best-known and most popular type of this tool. Morningstar's domestic equity style box, shown below, provides a simple equity classification system.

The vertical axis is divided into three categories, which are based on market cap. For mutual fund evaluations, Morningstar's proprietary market cap evaluation methodology is used to rank the underlying stocks in each mutual fund in order to determine the fund's market cap. Of the 5,000 stocks in Morningstar's domestic equity database, the top 5% are categorized as large cap. The next 15% are classified as medium cap, and the remaining stocks are classified as small cap. (For further insight, see "Market Capitalization Defined" and "Introduction to Small Caps.")

The horizontal axis is also divided into three categories, based on valuation. Once again, the underlying stocks in each mutual fund portfolio are reviewed. The price-to-earnings (P/E) and price-to-book (P/B) ratios are used as the basis of a mathematical calculation that results in the classification of each stock as growth, blend, or value. The term blend is used to describe stocks that exhibit both growth and value characteristics.

Together, the vertical and horizontal axes can be used to classify a mutual fund into one of nine categories:

• Large value
• Large blend
• Large growth
• Medium value
• Medium blend
• Medium growth
• Small value
• Small blend
• Small growth

This categorization system is useful in determining how an investment fits into a particular investment portfolio from an asset allocation perspective. Some investors use it to find a fund for each category, while others focus on specific areas. For example, an aggressive investor might focus primarily on small capitalization funds or growth funds. Still, a fund's placement in the style box is not only useful in selecting investments. It is also useful over the long term, where historical style box data can be used to verify the consistency of a portfolio's holdings. (To learn more, see "Achieving Optimal Asset Allocation.")

The very same style boxes that are used to evaluate mutual funds can also be employed to evaluate individual stocks and bonds; after all, the boxes are already used to evaluate each underlying security in a given fund before the data is averaged to provide a fund-level rating. Many investors are unfamiliar with this use of the style box; as a result of Morningstar's famous rating system for mutual funds, many other fund companies have adopted the placement of style boxes alongside the star-rating system, for marketing purposes, and this has overshadowed the tool's other uses.

In addition to the domestic equity style box, Morningstar offers two others: an international equity style box and a fixed-income style box.

This style box looks exactly like its domestic cousin, with market cap on its vertical axis and valuation along the horizontal axis. Although they look alike, they use different specifications for determining market caps and valuations. In the international equity style box, market caps are based on the median market cap of assets in a particular fund, with each asset being measured and factored into the whole. The valuations use the price-to-cash-flow ratio rather than P/E, which, arguably, makes for an easier comparison between securities, because earnings data may be calculated differently from country to country.

In addition to equity style boxes, there is a style box for fixed-income investments. Like the equity style boxes, the fixed-income style box can be used to categorize investments into one of nine categories. It measures credit quality on its vertical axis, rating investments as high, medium, or low. The horizontal axis rates interest rate sensitivity, as measured by the duration of the bonds in the portfolio (maturity). Duration categories include short, intermediate, and long. Each underlying bond in a fund's portfolio has a distinct credit quality rate and a set maturity date, making categorization easy.

While Morningstar gets most of the credit for the style box, most major North American mutual fund companies and personal financial services firms have adopted the style box, customizing it with their own conventions. For example, in equity style boxes the axes often change blend to core, and medium to mid. Proprietary categorization methodologies may also be developed for use in determining market caps, but most methodologies operate within reasonable parameters based on industry standards.

In addition to developing proprietary style boxes, research providers and securities analysts have gone beyond the use of this tool to evaluate mutual funds and individual securities, adopting it to evaluate and categorize money managers. Research analysts use the style box to develop hypothetical portfolios that combine various money managers. In this manner, high-net-worth investors can be shown how to create a diversified portfolio through the use of individual money managers. Historical data can be used to run a nearly endless variety of scenarios that give analysts, financial advisors, and investors the opportunity to consider the performance results and style consistency that would have resulted from combining various money managers in specific permutations and asset allocation percentages. The same type of analysis may also be done with individual securities.

Beyond investment selection, style boxes also play a role in monitoring whether or not a money manager stays true to its professed style. For example, a core manager that exhibits a tendency to purchase value stock would be labeled "core with a value tilt." If that manager suddenly begins to favor growth stocks, investors would want to make a note of this style drift and consider choosing a new manager if the addition of growth stocks conflicts with the desired asset allocation model or moves the portfolio in a direction that does not meet their long-term investment objectives. Because separate accounts are sold through professional financial advisors, your advisor can easily provide style box information should you wish to see it.

Whether you use a style box to review mutual funds, individual securities, or money managers, it is a simple and highly useful tool that will continue to play a role in investment evaluation. It can also help you determine the overall asset allocation of your portfolio by figuring out where your holdings fit in the box. Even if you never use a style box yourself, you can bet that the investment industry will continue to rely on this time-tested tool to market its products and to guide investors in their decisions.

To read more, see "Morningstar's Stewardship Grade Scores Big."