Understanding the Mutual Fund Style Box

Fact checked by Timothy LiReviewed by Julius Mansa

A style box represents a mutual fund’s characteristics. The financial services research provider Morningstar, Inc. popularized the tool by placing it alongside its mutual fund ratings system, which ranks mutual funds from one to five stars. As a result, many mutual fund investors are familiar with it and use it to evaluate and choose mutual funds.

It has several other applications. Read on to find out how style boxes can be used to categorize mutual funds and individual securities and help you understand how to build your portfolio.

Key Takeaways

• Mutual fund style boxes provide a representation, typically in a 3×3 grid format, for quickly gauging the fundamental characteristics of a mutual fund’s investment strategy.
• The style box categorizes funds based on market capitalization (large-cap, midcap, small-cap) and investment style (value, blend, growth).
• Investors and advisors use style boxes to compare and contrast different mutual funds.
• The style box can indicate a fund’s potential risk and return profile based on its category, given that different sectors and company sizes have varying levels of volatility and potential for growth.

A Look at the Box

The domestic equity style box is the most popular type of this tool and helps assess securities. Morningstar’s domestic equity style box, shown below, provides a simple equity classification system.

The vertical axis is divided into three categories based on market cap. For mutual fund evaluations, Morningstar’s proprietary market cap evaluation method ranks the underlying stocks in each mutual fund to determine the fund’s market cap. Of the 5,000 stocks in Morningstar’s domestic equity database, the top 70% are categorized as large-cap. The next 20% are classified as midcap, and the remaining stocks are classified as small-cap.

The horizontal axis is 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—key measures for a company’s health—are used to calculate and categorize each stock as growth, blend, or value. The term “blend” refers to stocks exhibiting growth and value characteristics.

How to Use a Style Box

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

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

This system is useful in determining how and whether an investment fits into a particular portfolio. Some use it to find a fund for each category, while others focus on specific areas. For example, an aggressive investor might concentrate on small-cap or growth funds. A fund’s place in the style box is not only helpful for selecting investments, but it’s also useful over the long term since historical style box data can be used to verify the consistency of a portfolio’s holdings.

As a result of Morningstar’s rating system for mutual funds, other fund companies place style boxes alongside the star-rating system for marketing purposes, which has overshadowed the tool’s other uses. Yet, the same style boxes can be used to evaluate individual stocks and bonds. After all, the boxes are already used for each underlying security in a given fund before the data is averaged to provide a fund-level rating.

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

International Equity Style Box

This style box looks like its domestic cousin, with a market cap on the vertical axis and valuation along the horizontal axis. Although they look alike, they use different measures to determine market caps and valuations.

For the international equity style box, market caps are based on the median market cap of assets in a particular fund, each factored into the whole. The valuations use the price-to-cash-flow ratio rather than P/E, arguably making it easier to compare securities because earnings data may be calculated differently from country to country.

Fixed-Income Style Box

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 categorizes investments into nine categories. It measures credit quality on its vertical axis, rating investments as high, medium, or low in this area. The horizontal axis rates interest rate sensitivity, as given 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 its own credit quality rating and a set maturity date, making categorizing them easy.

The Style Box Is Used By More Than Morningstar

While Morningstar gets much of the credit for popularizing the style box, most major North American mutual fund companies and personal financial services firms have adopted some form of it for their own products. For example, platforms and fund firms often change the blend to include core and medium to mid for equity style boxes.

Different firms also use proprietary categorization methods to determine market caps, but most use standard measures to keep things relatively the same across the financial industry.

Beyond Mutual Funds

Research analysts use the style box to develop hypothetical portfolios that combine various money managers. By doing so, high-net-worth investors can be shown how to create a diversified portfolio using individual money managers. Historical data can be used to run an almost endless variety of scenarios that give analysts, financial advisors, and investors a chance to review the performance and consistency of combining money managers in different ways. The same can be done with individual securities.

Besides selecting investments, style boxes help assess whether a money manager has remained consistent with a professed style. For example, a core manager who tends to buy value stocks would be labeled “core with a value tilt.” If the manager begins to favor growth stocks, investors can note this and consider a new manager if that doesn’t meet their long-term investment goals. Because separate accounts are sold through professional financial advisors, you can quickly get the style box information when needed.

What Is the Difference Between Value and Growth Stocks?

Value stocks are typically shares in larger, more established businesses trading for a lower price than an investor believes it’s worth. Growth stocks, meanwhile, are shares in companies that investors think are likely to grow faster than the competition. These are often the stocks of smaller companies or new businesses.

What Style of Fund is Best?

Style boxes can help you learn about the type of investments a fund owns, but no one style is guaranteed to perform better than others. Instead, there is a style that fits your specific goals. For example, more aggressive investors may look for small-cap, growth funds, while those looking for less volatility generally prefer value funds.

When Did Morningstar Introduce the Style Box?

Morningstar introduced it in 1992. Since then, Morningstar has refined and adjusted its methods for classifying different funds.

The Bottom Line

Whether you use a style box to review mutual funds, individual securities, or money managers, it’s simple and useful for allocating assets in your portfolio by figuring out where your holdings fit in the box. Even if you never use a style box yourself, the investment industry will continue to rely on this time-tested tool to market its products and help investors with their financial decisions.

Read the original article on Investopedia.