How to select the right mutual funds; check out the ‘style box’

Published: May 9, 2017 5:32 AM

Knowing the investing style of a fund helps you judge its performance and diversify your investment portfolio better

Morningstar, an investment research firm, provides visual summary of style in simplified nine-square matrix called ‘style box’ for mutual funds since 1992.

With increasing popularity of mutual funds, a new problem has popped up for investors. Selection and performance evaluation of mutual funds is becoming as important as that of stocks. Each mutual fund generally adopts an investment style or philosophy. Since predicting future performance using historical data is not a wise approach, investors should select a mutual fund based on the style of investing. It is the style mandate that decides the characteristics of stocks selected from the broad universe.

It is widely known that factors such as size (small cap over large cap), value (value over growth) and momentum (winners over losers) deliver significant alpha over the full market cycle.

Style box in mutual funds

Morningstar, an investment research firm, provides visual summary of style in simplified nine-square matrix called ‘style box’ for mutual funds since 1992. The two-dimensional graphic has remained very popular among equity fund investors with the size and style categorisation of the funds.

For equity funds, the style box represents the portfolio’s style (value, blend, or growth) and the asset-weighted size (large-, mid-, or small-cap). Similarly, for debt funds, it represents duration, or interest-rate sensitivity (short, intermediate, or long), and credit quality (high, mid, or low).

Each style has up and down cycles. If the current cycle is in favour of one style, the fund manager can generate the higher returns favoured by that style rather than stock picking abilities. If the fund manager generates good returns even during the trying times not favouring the style, then it is evidence of stock-picking skills.

The factors reward you by alpha over the market cycle. For example, value portfolio delivers outperformance during the economic revival. So, if the economy is sluggish, you can be patient with the underperformance of the value fund till the economy revives. Thus knowing the style helps judge the performance in the first place.

Highs and lows

If during a period, all the growth stocks are reaching new highs, you just need to pick up a good fund investing into such stocks to get the benefit of the tide. It is like if you know the direction of the flow of the river, then it is better to swim in that direction to generate speed without application of a high level of skills and efforts. Hence, one can select the fund with the desired style suitable for investor risk profile.

For example, a highly risk-averse investor may want to consciously avoid small-cap and growth investments. Also, knowing the current style of investment of a fund helps diversify while doing asset allocation across different style funds, selecting a fund in desired boxes of the grid as well as avoiding duplication at the stock level while buying different mutual funds.

Besides selection of fund, the style matrix also rescues you from a lesser-known problem of mutual fund investing: style-drift. Often fund managers get greedy and they switch from the pronounced style to other tempting style. It is often found that a large-cap value fund starts holding growth stocks or gets tilted towards midcap stocks in a hunt for returns.

Monitoring whether the fund manager is staying true to the stated style or not is important for the investor who has invested capital based on the style asserted by the fund house.

Knowing the current and historical style of a fund, one can see if the fund manager has surrendered to style-drift to lift the short-term returns. Investors needs to know this ‘style-drift’ as the tilt may not be acceptable to the investor on account of asset allocation or it may not be in line with their investment objective.

The author is faculty member in finance department at DSIMS, Mumbai

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