When deciding to invest in a mutual fund (or any other investment), it is generally accepted that a diversified portfolio reduces risk over the long term. The readers would have also come across findings and assertions along the lines that stocks do better than bonds over the long term, small cap stocks can be more rewarding than large cap stocks, junk bonds are riskier than treasuries, etc. What do all these terms mean? In this article, we will review the concept of a mutual fund stylebox, that was originally introduced by Morningstar, that can help visually illustrate these concepts and aid in developing a diversification strategy.

There areĀ  two basic styleboxes that we need to understand. One is for the stocks and the other is for the bonds. The key attributes that a stock stylebox reflects is the size of the stocks (in the fund) and the valuation of the stocks (in the fund). The bond (or fixed income) stylebox on the other hand reflects the credit quality of the bond and the duration of the bond (maturity). Each of the styleboxes are separated into 9 different quadrants that determine the style of the investment.

Stock or Equity Stylebox

Domestic Equity Stylebox

Domestic Equity Stylebox

A stock or equity stylebox consists of the market capitalization of the stock on the vertical axis. The classification of market capitalization of a stock in Large/Mid/Small cap normally vary but a general rule of thumb is any company above $10 Billion in market cap is a large cap company and any company below $2 Billion in market cap is a small cap company, with $2 B – $10 B range classified as mid-cap. Small caps could be further broken down into ultra-small-cap and micro-cap stocks.

Valuation of the stock is represented on the horizontal axis. Traditional industry measures of valuation such as Price-Earnings ratio and Price-Book ratio are usedĀ  to determine valuation for a domestic equity. For international equity, Price-Cash Flow measure may be used as the Earnings measurement differs across the globe due to differences in accounting standards.

From a risk perspective, small cap stocks are generally considered the riskiest with large cap stocks considered the safest. Additionally, the value stocks are perceived to have less risk than the growth stocks while offering higher potential returns.

Bond or Fixed Income Stylebox

Bond Stylebox

Bond Stylebox

Similar to Equities, the Bond stylebox has 2 axis displaying 9 different styles. The emphasis here is on the credit quality of the bond as well as the time to maturity or the duration of the bond. Vertical axis shows the credit quality, with High (AAA-AA), Medium (A-BBB), Low classifications. Typically government/municipal bonds and very stable corporate bonds are classified as High quality while junk bonds are Low quality bonds. Horizontal axis reflects the time to maturity of the bond. The shorter the time to maturity of the bond, safer it is as the company and economic risks are minimized. Similarly, highly rated bonds are deemed to be safer, although it should be noted that sometimes the rating agencies fall behind and do not completely reflect all the known information in their ratings (one of the main reasons for the mortgage crisis was the AAA ratings issued by the rating agencies on questionable mortgage debt securities).

While we have discussed the styles above in the context of stocks and bonds, mutual funds are classified using this style boxes using weighted averages over all their holdings. Therefore it is possible to find a short term high quality bond fund that has a portion of its portfolio invested in junk bonds.

Style drift: When investing in mutual funds, one should keep in mind that the reported style of a mutual fund may drift over time. For example, a small cap value fund can over time become a mid-cap blend fund if its holdings value increases and the fund did not replace the holdings that ran up in price. Generally this is not a problem if the fund manager sticks to his/her stated objective of the fund and the new investments are aligned with the objective. One should be wary of the funds where the style keeps changing randomly without any reason and not in line with the fund objective. This may be an indication of exessive trading (churn) and/or incompetence of the manager.

Caveat: While the styleboxes provide an easy way to classify one’s investments and develop an asset allocation strategy, they should not be the sole criteria for picking an investment. One needs to consider additional factors such as manager experience, past performance, fees and expenses, portfolio turnover, diversification, etc. There are a few well respected managers that run highly concentrated portfolios with little regard for styleboxes and have generated outstanding returns for the investors. You can analyze the horse and the weather and other things all you want but if you do not have the right jockey than your bet is still going to be very risky.