How to make the most of the Morningstar Style Box

Since we introduced the Morningstar Style Box for funds in 1992, it has become a standard way for fund companies, advisers, and individual investors to categorise funds. It's intended as a handy visual summary; by knowing where a fund lands in the nine-square style box, you can tell quite a bit about how a fund manager tends to invest and where a given fund might fit into a portfolio.

However, it's important to remember that the style box is just a summary. It has its limitations like any tool, but if you know where to look, it's possible to find quite a bit of useful information to supplement what a fund's style box tells you. Specifically, a fund's centroid and Morningstar Ownership Zone allow you to pinpoint its characteristics much more precisely and compare them with those of similar funds.

Style boxes and categories

Before we get into the details, it will be helpful to establish just what the style box is and what it isn't. It's meant as a snapshot of a fund's portfolio at a given moment in time, showing the types of securities that the fund actually owns. For stock funds, the style box represents the portfolio's style (value, blend, or growth) and the median size of its holdings (large-, mid-, or small-cap); for bond funds, it represents duration, or interest-rate sensitivity (short, medium, or long), and credit quality (high, mid, or low).

It's important to note that a fund's style box is not the same as its category. That can cause some confusion for funds in categories corresponding to the nine squares of the style box--for example, we have a large-growth category, and a fund's most recent portfolio may also land in the large-growth square of the style box. The style box and the category usually correspond for such funds, so that a fund in the large-blend category, for example, lands in the large-blend section of the style box. Sometimes, though, the two will differ.

The reason that such discrepancies can happen is that the style box is a snapshot of one moment in time, whereas fund categories are meant to be much more stable and consistent. Every time a fund releases a new portfolio, its style box is automatically updated to reflect that portfolio. That means that, in theory, a fund could move around in the style box several times in a single year. A fund's category, on the other hand, generally stays the same unless there's a pronounced shift in its portfolio or strategy. If a fund's style box and its category have been consistently out of sync for three years or more, we're likely to move the fund to a new category, though even then the change isn't automatic.

Centroids and Ownership Zones

All this raises another question: What does it mean, exactly, to say that a fund lands in a certain square of the style box, such as large blend? To answer that, we need to look in a little more detail at what goes into the style box. First of all, each stock in a portfolio gets a size score, determined by its market cap, and a style score, determined by combining five valuation measures and five growth measures. These two scores--size for the vertical axis, style for the horizontal axis--can be used to plot where that stock lands in the style box. (For more on how this works, see our style box fact sheet.) By combining the asset-weighted size and value scores for all of a fund's holdings, we get size and value scores for the fund as a whole. The point where these scores intersect on the style-box grid is the fund's centroid, which determines in which of the nine boxes the fund goes. For simplicity's sake, we'll focus here on the equity style box, because the features we're interested in (centroid and Ownership Zone) are not part of the fixed-income style box.

You can find any fund's centroid by going to its pdf report on Morningstar.co.uk and looking at the style box in the lower left. A large red dot represents the centroid. This information can be very useful in making finer distinctions than the style box alone is capable of.

The Ownership Zone is represented by a shaded area surrounding the centroid. This zone encompasses 75% of a portfolio's holdings on an asset-weighted basis, and it's designed to be a visual measure of how wide-ranging the portfolio is. A fund that focuses almost entirely on one type of stock will have a small Ownership Zone, while one that gets its holdings from all over the style box will have a much larger Ownership Zone.

Below the large style box with the centroid and Ownership Zone for the fund's most recent portfolio, you'll also find the Investment Style History, which shows where the fund landed in the style box in each of the past three years. This can give you some idea of how consistent a fund has been in style-box terms.

What it all means

So, what does all this mean for you? For one thing, centroids and Ownership Zones can be helpful in figuring out how a fund fits into a portfolio. A fund that provides "pure" large-growth exposure and could be useful for balancing up a portfolio with a value tilt or adding a little growth pop to an otherwise staid portfolio. A fund with a huge Ownership Zone is less useful as a pure large-growth fund and better employed as a broadly diversified core holding. Conversely, you might discover that two funds in your portfolio have very similar centroids and Ownership Zones despite being in different categories and/or style boxes, and thus they could be redundant with one another. Of course, there are plenty of other factors to consider here, but centroids and Ownership Zones provide some additional tools.

You can also use the portfolio tools on Morningstar.co.uk to track where your portfolio as a whole lands in the style box. The Instant X-Ray allows you to input any portfolio and see what percentage of the holdings land in each of the nine style-box squares and which square the whole portfolio would land in. If your portfolio isn't where you want it to be--say, if it's more growth-oriented than you thought--then it might be a good time to rebalance. Premium Members of Morningstar.co.uk can click on the X-Ray tab in Portfolio Manager to get the same information, plus more.

A version of this article appeared on Morningstar.com May 13, 2008. David Kathman is a fund analyst with Morningstar.com.