How to find a great core stock fund

Does the recent rally in stocks have you wondering whether your portfolio is positioned to get a piece of the action? Rather than bet on a specific market sector that you think will perform best, your best option is to make sure your portfolio includes at least one well-diversified core stock fund.

To help simplify the job of identifying core funds, Morningstar analysts divide funds into one of three groups. We call the more important ones "core" funds and the less important ones "supporting" funds; we consider niche offerings like sector and regional funds to be "specialty," meaning you should relegate them to a small percentage of your portfolio. Morningstar users can see these designations (for funds that have analyst coverage) on the right-hand side of the fund Snapshot page, under "Portfolio Role".

This article will highlight one type of fund--diversified domestic large-cap funds--that can often serve as core stock holdings in a portfolio. Knowing that your portfolio includes a rock-solid core can help you better cope with the extreme volatility that has plagued the market in recent months and can also help ensure that your portfolio will participate in a rebound in the equity market.

Why large caps?

Typically a core stock holding is a large-cap fund. That's because the market is made up of mostly large-cap stocks. (A stock's market capitalisation, or 'cap,' is its number of shares outstanding multiplied by its price per share.) In fact, large caps account for about 80% of the FTSE All Share Index. This is primarily why advisors put the bulk of their clients' money in large-cap stocks or funds and why Morningstar designates most funds that own large-cap stocks as "core" holdings. You're simply getting exposure to a bigger slice of the market when you own a large-cap fund than when you own a mid-cap fund, small-cap fund, or a fund dedicated to a particular sector or industry of the economy.

Does this mean that you must always have 80% of your stock exposure in large caps? Not at all. Different allocations may be appropriate for different investors. However, it's important to know what the market looks like, if for no other reason than to understand how you might be deviating from it.

Given that small caps have outperformed large over very long time periods, a question that naturally arises is "Why does my portfolio have to look like the market with all those lacklustre large caps?" And it's true that large, established companies are subject to the same problems as other kinds of companies. They can get overpriced, as we saw during the bubble years (2000-02), and they can engage in large-scale deception and fraud as we saw with Enron. But large caps tend to be steadier over extended periods of time than smaller stocks, giving investors the courage to stick with them through the rough patches. In short, they tend to be solid businesses with steady profits that compound your money decently over time.

Also, there are times when large caps do better than the rest of the market. Although small- and large-cap funds have suffered equally in the market's sell-off over the past year, many of our favorite fund managers believe that high-quality, large-cap businesses look as cheap now as they have in a long time. And in 2008's rough market, companies with steady earnings and profits--as well as what Morningstar's stock analysts call wide economic moats--generally outperformed less consistent firms. If the economy slows, large-cap stocks tend to hold up better than their smaller counterparts for a variety of reasons. Multiple product lines (often with brand-name recognition), market dominance, multiple customers often spread around the world, greater access to capital, and generally stronger management teams are some of the reasons why larger businesses can withstand difficult economic times. We certainly don't advocate dumping all your small-cap funds, but now may be a particularly good time to recheck your allocation and make sure that your core holdings are beefed up enough.

Additional considerations

If you've decided that you want to use a large-cap fund as a core holding, there are a few other factors to bear in mind. First, you should consider fees. Although it may not seem like a big difference whether you're paying 1% or 2% as an expense ratio, fees cut into returns dramatically over time. Additionally, even if the stock market returns 8%-10% in the future--in line with historic norms--keep in mind that inflation has historically run at more than 3%, meaning that stocks have increased your purchasing power by only 5% to 7%. In other words, every percentage point counts when it comes to trying to beat inflation, and you should try to pick a fund for a core holding that has an expense ratio of around 1% or less.

Second, if you're picking an actively managed fund (instead of one that simply tracks an index like the FTSE 100), look for an experienced manager with a solid track record. As in other professions, experience counts in the investment world, and you want to make sure that the manager has weathered market storms reasonably well and has stuck to his investment style when it was out of favour. Morningstar analyses tend to focus lots of attention on a fund's management team, and there's a management section beside every analysis telling you what we think of the manager and analyst staff at a particular fund.

Third, consider an index fund--especially one that follows the FTSE 100 Index or the FTSE All Share Index--as a core holding. Index funds are generally low-cost options that virtually guarantee to get you nearly all of the market's return. This doesn't make them safe in the sense of being good at preserving capital, because markets can decline dramatically from time to time. However, most actively managed funds have a hard time beating the major indices, so an index fund can relieve you of the burden of searching for one that has in the past and that has a good chance to do so in the future; you also won't have to worry about changes in management or strategy.

John Coumarianos is a fund analyst with Morningstar.com.