Don't let `style' of fund put managers in a box

Your Funds

July 03, 2005|By CHARLES JAFFE

ONE EMERGING TREND on display at the recently completed Morningstar Investor Conference here was out-of-the-box thinking.

The box, in this case, is Morningstar's ubiquitous style box, a measure that was designed to help fund investors but which has actually hindered some fund managers - and some shareholders - over the years.

For the typical investor relying on a style box - or on a Lipper Inc. category - to define the kind of fund they are buying, the debate comes down to some old-school thinking, going back to a time when investors wanted a manager for his or her style, rather than a fund for the style box it fits into.

Style boxes were developed by Morningstar as a way to categorize mutual funds, to describe the investments that a fund buys. It's a nine-box grid - think tic-tac-toe board - that shows where the fund buys its groceries, and the cooking style on the menu.

The vertical columns represent whether management buys growth stocks, value stocks or a blend of the two. The horizontal rows represent the market capitalization of the securities the fund invests in.

The result is that a large-cap growth fund gets the top right box, while a small-cap blend fund is ascribed to the center spot on the bottom row.

The problem is that once a manager is assigned to a box, the description can become a straitjacket. "Style drift" - moving from one box to the next - was publicized as a huge problem for investors building portfolios that relied on a specific asset allocation.

Funds that were hard to define, or that moved based on the best ideas of the manager, got no love from the advisory community; fund managers wanting to gather assets, therefore, wound up constrained by the boxes in order to attract assets.

In 1999, in a keynote speech I gave at the Morningstar conference, I warned that "style commandos" were dictating strategy, and that "management hostages" were allowing it to happen.

That trend finally seems to be easing, albeit slowly.

Style boxes are good when they keep an investor from getting a false sense of diversification after investing in a few funds. Having investments that cover the bulk of the grid is good form in asset allocation.

But obsessing about which boxes are covered and worrying when a fund moves slightly is overkill.

It was clear at the conference that a growing number of planners are less concerned about boxing a fund in than about the manager's investment process and results.

Morningstar itself created "ownership zones," which show the entire spread of holdings in the style-box system. Most funds are centered in one box, but have holdings that spread into others. How far afield they go is a good indicator of whether the fund sticks to one zone or moves around.

Ed Favreau, of the Leuthold funds, noted that financial advisers shunned his firm's Core Investment fund for years because management did not stick to one style box.

That freedom, however, was a big part of the fund's identity. Management was practicing tactical allocation - the fund's ownership zone snapshot actually shows investments in all nine grids of the style box - and moving from one part of the market to the next was a fundamental part of the strategy.

Throughout the conference and exhibit hall this week, the top fund managers noted repeatedly that they search for investments based on their own discipline, and not based on what box they are lumped in.

Not all advisers like the idea of backing away from reliance on the box, but individual investors should be intrigued.

After all, the first six decades of mutual funds - the ones before the style box - were all about getting professional management and diversification at a reasonable price. Limiting a manager's ability to go where the best bets are based on their personal investment criteria reduces the chances for the manager to be effective.

In fact, there is a very good case for saying that if what an investor wants is a specific allocation to certain asset categories or style-box grids, they can best build that kind of portfolio using index funds and exchange-traded funds.

"You need to know where the funds are deployed, but it doesn't make sense to fire a great manager - or to ignore one - for using their discipline to make money," says Don Phillips, Morningstar's managing director and the guy who developed the style box.

"The key is knowing what a manager does and asking questions if you see a radical and unexpected change. But if you are paying for active management, let it happen, and don't worry so much that your large-cap value fund let some winners run and is now more of a large-cap blend fund. You're paying the manager to make those decisions."

Charles Jaffe is senior columnist for MarketWatch. He can be reached at jaffe@marketwatch.com or Box 70, Cohasset, Mass. 02025-0070.

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