
Morningstar Guide to Mutual Funds
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Understanding The Morningstar® Style BoxT
A desire to help investors choose funds based on what they really own-instead of on what funds call themselves, how they classify themselves, or how they've performed recently-was precisely what inspired Morningstar to develop its investment style box in the early 1990s. The style box provides a quick visual summary of a given fund's portfolio, showing you, using a nine-box investment-style grid, where most of your fund's portfolio is invested. (To check out a fund's current style box, go to Morningstar's Web site, www.morningstar.com, and type in a fund's name or ticker.) While investors needn't own a fund from each and every square of the style box, the tool can help you know whether your portfolio is diversified. If all of your funds are huddled in a single corner of the style box, that's a tip-off that you'll probably want to spread your bets around more. The style box also helps investors keep track of whether a fund has changed its approach, because we update each fund's style-box placement every time we receive a new portfolio. If a fund that you bought to bring your portfolio exposure to the fast-moving technology and telecom industries is suddenly delving into the securities of small manufacturing firms, you'll see that change reflected in your fund's style-box placement. For stock funds, the style box isolates two key factors that drive its performance: the size of the stocks the fund invests in and the type of companies it buys-rapidly growing companies for which investors are willing to pay a pretty penny, slower growers that trade at lower prices, or a combination of the two (see Figure 1.1). Those two factors-company size and investment style-form the two axes of the stock, or equity, style box. For bond funds, the style box focuses on the two key determinants of bond-fund behavior: a fund's sensitivity to changes in interest rates and the credit quality of the bonds in which it invests. Those two factors form the axes of the bond-fund style box (see Figure 1.2). Once we have determined the size and investment-style coordinates for a stock fund and the interest-rate sensitivity and credit-quality coordinates for a bond fund, we can use our nine-square style box grid to show investors-visually-where their fund lands. Figure 1.1 The Morningstar stock style box is a nine-square grid that provides a quick and clear picture of a stock fund's investment style.
Using the Stock-Fund Style Box
To figure out which square of our stock style box a fund portfolio lands in, we first analyze each and every stock in that portfolio. We begin by grouping each stock in a portfolio into one of seven regions: the United States, Latin America, Canada, Europe, Japan, Asia ex-Japan, and Australia/New Zealand. Once we've placed a stock within one of our regional zones, we then go on to evaluate how it stacks up relative to other firms within that same zone. We start that process by determining whether a security is small, medium, or large within its region. In investing parlance, stock size is often called market capitalization, or market cap. Market cap sounds like a technical term, but it's not particularly hard to understand-essentially, it's the current dollar value of all of a given company's stock shares. So if a stock is selling for $30 and there are a million shares of it floating around in the market, the company has a market cap of $30 million. We consider companies whose market caps land within the largest 70% of their region to be large cap; the next 20% are midcap; and the smallest 10% are small caps. Although small-cap stocks only account for 10% of each region's market, there are actually many more of them than there are large-cap companies. Figure 1.2 The Morningstar bond style box is a nine-square grid that provides a quick and clear picture of a bond fund's investment style. Having determined a security's regional and size classification, we turn our attention to its investment style. Investing aficionados typically group stocks into one of two major buckets-growth stocks or value stocks-and often identify themselves as growth investors or value investors. Understanding the difference between the two styles is critical to understanding what makes a fund tick. Growth stocks typically enjoy strong growth in earnings or revenues because they've got a hot new product or service. Because the market expects good things from these fast growers, and earnings growth usually drives a higher share price, investors are willing to pay more for the shares than they will pay for slower growers. Value stocks, conversely, look like growth stocks' less successful cousins. These companies' earnings are usually growing slowly, if at all, and they often operate in industries that are prone to boom-and-bust cycles. So why does anyone bother with these underachievers? The answer is, because they're cheap. Fund managers who focus on value stocks are willing to put up with lackluster earnings growth because they think the market is being overly pessimistic about the company's future. Should things turn out better than the market thinks, the bargain-hunting fund stands to...
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