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  1. The Morningstar Approach to Mutual Fund Analysis—Part I Chapter 9

  2. CYCLE OF FEAR AND GREED • The mutual fund industry has done a remarkable job of creating scores of fine, reasonably priced funds that can meet almost any conceivable investment need. Unfortunately, however, good funds do not always translate into good results for investors.

  3. Even when using high-quality investment vehicles, such as low-cost, broad market index funds, investors too often buy high and sell low. The resulting damage from poorly timed buy and sell decisions can sabotage investors’ returns and represents what may well be considered the Achilles’ heel of investment management.

  4. Both investors and fund companies share part of the blame for investors’ suboptimal use of the industry’s fund offerings. No one wins when investor are enticed to throw money at an overheated market or are tempted to pull out after a sharp correction, but little has been done to curb the practice. Fund companies do not run ads discouraging investors from buying their hottest funds, nor do they tout the recent losses of their most out-of-favor funds.

  5. Instead, the mutual fund marketing machine often amplifies the cycle of investors’ fear and greed—promoting aggressive funds at the market’s peak and more conservative offerings at its trough. • At Morningstar, we have tried to shine a light on this problem of poor fund usage by publishing a metric that we call Investor Return TM. It is a money-weighted performance calculation that weights performance in periods when more money is in a fund more heavily than those periods when less money is invested.

  6. It gives an approximate feel for how much money a fund makes (or loses) for investors in the aggregate. This calculation differs from traditional total return, which is a time-weighted calculation that assumes all of an investor’s money goes in at the beginning of the evaluation period and remains in place with no additions or withdrawals. • Total return remains the most appropriate way to evaluate a fund manager’s prowess, but the Investor Return metric helps show how well the average investor has actually fared in a fund.

  7. Sadly, investor returns almost always trail total returns, as investors tend to chase past performance and buy funds only after a good run. Not surprisingly, the gap between investor results and stated fund performance widens as fund volatility increases and investor resolve is tested. For relatively staid investment vehicles such as balanced funds, the gap is typically small, perhaps just 20 basis points (0.20 percent) per year. For domestic equity funds as a whole, the gap was roughly 187 basis points per year over the 10-year period ended December 2007.

  8. For higher-volatility funds, such as sector funds or emerging-market stock funds, the gap can often be in excess of 300 basis points per year. For more aggressive investors, this hidden cost can easily dwarf the impact of fund fees in terms of undermining investment success. • Clearly, this behavioral aspect of investing is at least as important as seminal investment considerations such as asset allocation and security/fund selection.

  9. It is only when all three aspects of the investment process—asset allocation, security/ fund selection, and investor behavior—are working in concert that investors are apt to succeed. By becoming proficient in all three stages, investors and their advisers can moderate the fear-and-greed cycle and make meaningful progress toward their goals.

  10. RISK MANAGEMENT • As Investor Return statistics show, trying to chase after hot funds is a losing game. A more prudent and usually more rewarding strategy is to take a long-range view and focus on balancing return and risk by building a diversified portfolio of securities. Tomes have been written by Nobel Prize winners and other leading scholars on the mathematical justification for risk management and portfolio diversification, but for our purposes here, suffice it to say that risk matters and diversification is critical.

  11. As the academic community has taught us, investment risks come in many shapes and sizes. One type of risk, known as systematic risk, results simply from choosing to invest in a given securities market. Systematic risk is sometimes referred to as market risk or macro risk, and represents the generic risks of investing in a certain asset class or security type. Unsystematic risk, however, is the risk that is specific to an individual security rather than to a whole class of securities.

  12. An investor who owns shares in IBM, for example, takes on the systematic risks of the stock market and the technology sector as well as the unsystematic risks associated with IBM—as defined by that company’s specific competitive pressures, product line, stock valuation, and so forth. • Anyone who invests is exposed to certain systematic risks that can be managed and mitigated through portfolio construction and diversification. As for unsystematic risk, some investors believe it makes more sense to minimize unsystematic risk and cost by investing in market-mimicking index funds, sometimes referred to as a passive investment strategy.

  13. Others believe in a more active strategy, where the investor takes on certain unsystematic risks, picking certain securities over others, in an effort to beat the market. Whichever the strategy, understanding different types of securities, the systematic and unsystematic risks they present, and how the securities work together when combined in a portfolio should be a key priority for any investor.

  14. APPROACHES TO PORTFOLIO CONSTRUCTION • Portfolio assembly is more art than science. There is no one right way to do it, but there are plenty of wrong ways. • The first step to successful portfolio construction is to determine the desired level of complexity. A good portfolio can be as simple as one fund, especially with the recent proliferation of well-constructed target date and target risk funds. Target date funds, which offer a diversified blend of securities that shift appropriately in asset allocation over time, are a great choice for individual investors who are new to investing.

  15. Target risk funds maintain a relatively stable asset allocation over time in order to maintain a fairly stable level of risk. Choosing a lower-cost target date or target risk fund from a well-known firm leaves relatively little room for error. The only trick is accurately matching investor time horizon or risk tolerance with that of the fund. As funds increasingly make these criteria explicit in their names, the potential for a mismatch narrows. There are, however, degrees of difference between the approaches taken by major institutions, and at least some due diligence into the chosen fund’s investment approach is warranted.

  16. For those investors who want to more finely tune their portfolios, `a la carte portfolio construction remains a popular option. This approach is the most widely used among financial planners, who often believe that their knowledge of their clients’ financial situation gives them insights into the asset allocation appropriate for each client. Investors or advisers who opt for customized asset allocations then fall into three camps for implementation of their plans. Some opt for the simplicity low cost, and dependability of index funds. Others try to add value through the selection of active managers.

  17. They will most often use actively managed funds, separate accounts, and occasionally hedge funds. Still others forgo outside managers and select at least some portion of the stocks and bonds used in the portfolio themselves. These options require substantially more research effort to ensure that the resulting portfolios are appropriate and stay on track to meet investor goals. • Any of these approaches can succeed if the investor’s level of skill, commitment, and resources is appropriate for the level of sophistication selected. The key with any approach is understanding the portfolio implications of individual investment decisions.

  18. Whether your portfolio contains 1 fund or 20 funds, your choices will have performance and risk implications that must be understood and managed if you are to stay onboard and successfully meet your goals. In the next section, we describe how to use Morningstar tools as a lens through which to understand and even visualize the portfolio implications of investment selections. Only by knowing where you stand can you determine if you are pointed in the right direction.

  19. TOOLS FOR ANALYZING FUNDS • Understanding investment portfolios starts with understanding the underlying components, whether they are individual securities or funds made up of individual securities. We begin by discussing some key tools for analyzing mutual funds but ultimately come around to how to analyze the nature of the underlying securities in a fund, an essential piece of the fund analysis and portfolio construction process.

  20. Morningstar Category • Morningstar provides a wealth of information and analysis about each mutual fund in its database. In order to use this information effectively, it makes sense to begin with the Morningstar category. Each U.S.-sold fund is placed into 1 of 70 categories, based primarily on the fund’s largest systematic risk exposures. We believe that placing a fund into the proper category is one of the most important pieces of analysis that Morningstar performs.

  21. The categories enable meaningful comparisons among similar funds and make it easier to assess potential risk, identify the top-performing funds, and build well-diversified portfolios. • Morningstar does not use the investment objective stated in a fund’s prospectus to place it in a category because the stated objective may not reflect how the fund actually invests. Rather, the category is assigned based on the underlying securities in each portfolio. Morningstar places a fund in a given category based on its portfolio statistics and compositions over the past three years.

  22. If the fund is new and has no portfolio history, Morningstar estimates where it will fall before giving it a more permanent category assignment. When necessary, Morningstar may change a category assignment based on recent changes to the portfolio. Morningstar regularly reviews and updates the list of categories to reflect changes in the fund industry. The categories described in this chapter are based on classifications as of 2007, and please visit for the most updated list of categories for U.S.-based mutual funds.

  23. The Morningstar categories are organized into five broad groups: 1. Balanced 2. U.S. stock 3. International stock 4. Taxable bond 5. Municipal bond • Let us consider each group and the categories within each group.

  24. Balanced Funds • An investor who decides to build a portfolio consisting of a single fund would most likely use a balanced fund from one of these categories: • Conservative allocation • Moderate allocation • World allocation • Target Date 2000–2014 • Target Date 2015–2029 • Target Date 2030+

  25. These funds combine stocks, bonds, and possibly other asset classes to provide a well-diversified portfolio in a single fund. The three allocation categories generally maintain a consistent exposure to stocks, bonds, and interest-bearing cash over time. Conservative- and moderate-allocation funds have more than 60 percent of their assets invested in U.S. securities. The difference is that conservative-allocation funds have 20 to 50 percent of their assets in stocks while moderate-allocation funds devote 50 to 70 percent of assets to stocks.

  26. World-allocation funds have at least 40 percent of their assets invested in non-U.S. stocks and bonds, and have a stock allocation between 20 and 70 percent. By selecting one of these funds, you easily maintain diversified exposure to stocks, bonds, and cash. Of course, in order to pick the right one for you, you need to find one that has the combination of asset classes that best meets your needs and goals. • The three target-date categories make up a special class of funds that are specifically designed for retirement savings. Generally, these funds come in sets with each fund specifying a target year for retirement or other savings goal.

  27. For example, a fund family may offer five funds with target years 2010, 2015, 2020, 2025, and 2030. As each fund approaches the target year, the stock exposure is reduced and the bond and cash exposures are increased. The path of the changing asset mix over time is known as the glide path. Some glide paths continue past the target date under the theory that investors should continue to become more conservative as they age during retirement.

  28. To use these funds, you would first pick a fund family and then choose the individual fund that has a target year that most closely matches the year of your planned retirement or other goal. Before making a selection, keep in mind that different families can vary widely in their approaches: how much they invest internationally; how much they invest in asset classes beyond stocks, bonds, and cash; their styles of stock investing; their asset mixes; and their glide paths.

  29. U.S.-Stock Funds • U.S. investors who decide to build a portfolio of funds rather than relying on a single balanced fund will most likely hold a significant stake in U.S.-stock funds. U.S.-stock funds can be used for three purposes in a U.S. investor’s portfolio: • 1. They can form the core of the equity portion of the portfolio. • 2. They can add exposure to particular segments of the U.S. stock market, either for diversification purposes or to enhance return. • 3. They can provide an exposure to a manager whom the investor believes has skill in either a broad or narrow segment of the U.S. stock market.

  30. A U.S.-stock fund is defined as one that has at least 70 percent of its assets in U.S. stocks. If the fund is not focused on a particular economic sector, Morningstar places it into one of nine categories based on the market capitalization (cap for short) and the value/growth orientation of the stocks held over the past three years. This is because research over the past few decades has identified market cap and value/growth orientation as two major systematic risk factors of stock markets. Market cap refers to the total value of a company’s stock and is often used as a proxy for the size of the firm.

  31. Value/growth orientation refers to investment styles. Value investors focus on stocks that are perceived as undervalued, expecting that these stocks’ worth eventually will be recognized by the market. Growth investors, however, seek securities with high rates of revenue or earnings growth. Many investors adopt elements from both approaches. Market cap and value/growth orientation are discussed in more detail in Chapter 10. • Reflecting the nine squares of the Morningstar Style Box, these nine categories can be arranged in a grid as shown in Exhibit 9.1.

  32. Investment advisers generally recommend that U.S. investors hold a diversified portfolio of large-cap stocks. Since blend funds hold diversified portfolios of value and growth stocks, you can use large blend funds to form this part of your portfolio. An alternative is using a combination of large-value and large-growth funds. • Many funds that Morningstar categorizes as large cap also hold mid-cap and small-cap stocks. If the mid-cap and small-cap exposures of your large-cap funds are insufficient, however, you can increase your exposure to stocks of smaller companies with funds in the mid-cap and small-cap categories.

  33. Funds from any of the nine style-based categories can be used to tilt your portfolio toward styles that you wish to emphasize. You also may be willing to deviate from your ideal blend of styles and court some extra unsystematic risk in order to gain exposure to one or more managers whom you believe are particularly talented. • Morningstar also includes several other U.S.-stock categories. Funds that invest at least 50 percent of their assets in a single economic sector are placed in one of the specialty categories.

  34. Funds from any of the nine style-based categories can be used to tilt your portfolio toward styles that you wish to emphasize. You also may be willing to deviate from your ideal blend of styles and court some extra unsystematic risk in order to gain exposure to one or more managers whom you believe are particularly talented. Morningstar also includes several other U.S.-stock categories. Funds that invest at least 50 percent of their assets in a single economic sector are placed in one of the specialty categories.

  35. International-Stock Funds • Stock funds that have at least 40 percent of their assets in non-U.S. securities fall into the international-stock categories. Funds that have less than 20 percent of their assets in U.S. securities and are geographically diversified in developed economies are classified into five style-based categories, which can be arranged in a grid as shown in Exhibit 9.2.

  36. Funds in these categories can be used in the non-U.S. part of your portfolio in the same ways that funds in the style-based U.S.-stock categories can be used in the U.S. part. You can use either foreign large-blend funds or combinations of foreign large-value and foreign large-growth funds to form the core of the non-U.S. stock part of your portfolio. Funds from any of these categories can be used to bias your non-U.S. stock exposure toward styles that you wish to emphasize. You also may be willing to deviate from your ideal blend of non-U.S. styles in order to gain exposure to one or more managers whom you believe are particularly talented.

  37. In international stock investing, the geographic location of a stock is also viewed as a systematic risk factor. Many international-stock funds specialize in a particular country, a geographic region, or emerging markets. The Morningstar categories for these funds include: • Europe stock • Japan stock • Pacific/Asia ex-Japan stock • Diversified Pacific/Asia • Diversified emerging markets • Latin America stock

  38. There are at least three ways to use funds in these categories: • 1. Combine funds from across these categories to build your own geographically diversified non-U.S. stock portfolio (as part of your overall portfolio). • 2. Use funds from one or more of these categories to create a geographic bias. • 3. Select funds from these categories that have managers whom you believe are particularly talented, possibly introducing biases into your overall portfolio.

  39. One additional international-stock category is the world-stock category. Funds in these categories hold diversified portfolios of stocks in the United States and the developed markets of Europe and Asia, with the U.S. exposure between 20 and 60 percent. These funds provide global diversification in a single fund.

  40. Taxable-Bond Funds • Bond funds can be used to form the fixed-income portion of a diversified portfolio. Like stock funds, bond funds can be used in at least three ways: • 1. They can form the core of the fixed-income portion of the portfolio. • 2. They can add exposure to particular segments of the bond market for either diversification purposes or to enhance return. • 3. They can be used to gain exposure to a manager believed to have skill.

  41. With fixed-income investments, there is the additional twist of tax treatment. The income from municipal bonds (bonds issued by state and local governments) is exempt from federal taxes and also from state taxes if you are a resident of the same state as the issuer. This is why Morningstar divides bond funds into two broad groups: taxable-bond funds (which have no special tax treatment) and municipal-bond funds (which are treated specially for tax purposes).

  42. As a general rule, for the taxable portion of your portfolio, you should hold taxable-bond funds if you are in one of the lower tax brackets or municipal-bond funds if you are in one of the higher tax brackets, but not both. To decide which is right for you, it is wise to compare after-tax yields using your marginal tax rate. For the portion of your portfolio that you hold in tax-advantaged accounts, such as individual retirement accounts (IRAs), hold taxable-bond funds.

  43. The most important systematic risk factors for bonds are duration, credit quality, and issuer. The longer out into the future a bond’s payments are, the longer its duration and the more sensitive its price to changes in interest rates or yields. A bond’s credit quality measures how likely the bond issuer is to make all of its scheduled payments. All other things being equal, the lower a bond’s credit rating, the lower its price and the higher its yield. A bond issued by the U.S. government or one of its agencies has the highest credit quality because no one expects the U.S. government to default on its obligations.

  44. Bonds issued by corporations that are unlikely to default are investment-grade bonds. Bonds in which the likelihood of default is high are referred to as junk bonds. Because junk bonds have high promised yields, they are also called high-yield bonds. • Morningstar categories for taxable U.S.-bond funds are organized around those factors most related to systematic risk—issuer, duration, and credit quality—as depicted in Exhibit 9.3.

  45. For minimal interest-rate sensitivity, but possibly the lowest returns, consider ultrashort bond funds. If you are willing to take some credit risk in the hope of earning additional returns, you can add funds from multisectorand high-yield bonds, but you probably want to do so in a limited way.

  46. The first row contains categories of funds that focus on U.S. government and agency bonds. The second row contains categories of funds that focus on investment-grade bonds. In the third row, multisectorbond funds are those that hold a blend of investment-grade and high-yield bonds. High-yield bond funds, being of the lowest credit quality, appear in the bottom row. The columns are arranged by duration, with the first column containing categories of funds that hold securities with cashlike durations. Ultrashort bond funds hold investment-grade issues with durations that are less than a year, and bank-loan funds invest in risky floating-rate bank loans.

  47. The remaining columns represent more rate-sensitive intermediate-term and long-term funds. • This grid can be used much like the stock category grids in Exhibits 9.1 and 9.2. You probably would use intermediate government or intermediate-term bond funds to form the core of the fixed-income portion of your portfolio. If you are willing to take the risk of long-term bonds in the hope of earning higher returns, you should consider long government or long-term bond funds. If you want to take on less risk and are willing to earn lower returns, consider short government or short-term bond funds.

  48. One additional U.S. taxable-bond category not captured in the fixed-income grid in Exhibit 9.3 is inflation-protected-bond funds. These funds invest in bonds that adjust their payouts to keep pace with inflation. The largest single issuer of these securities in the United States is the U.S. Treasury, which issues TIPS (Treasury Inflation-Protected Securities). Because the payments made by conventional bonds are fixed, there is risk that future inflation will erode their purchasing power. Inflation-protected-bond funds protect their investors from this risk.

  49. Funds that invest mainly in non-U.S. bonds are classified in one of two categories: world-bond funds and emerging-markets bond funds. World-bond funds invest 40 percent or more of their assets in bonds issued outside the United States, with at least 35 percent of their assets invested in developed countries. Emerging-market bond funds invest more than 65 percent of their assets in emerging-market countries.