At different points in the business cycle, different investments will perform better than others will, and it is important to differentiate between different sectors and styles of investments. If we were to award a prize for companies that innovate on behalf of investors, Morningstar would likely be the first recipient. Morningstar supplies investors with huge amounts of information on nearly every investment instrument you can think of. Most of this information is free to the public via their website.
One of the best teaching aids available when it comes to different styles of investments is the Morningstar style box. The style box for each asset category is different because different factors are critical in the valuation of different types of investments. This means that there is a style box or every major asset class. Later on, we will discuss the importance of being diversified across asset classes. We will also stress the importance of being diversified within asset classes, and the style boxes are an excellent tool for helping us conceptualizing what that means. The boxes are tables, and each cell of the table represents a style of asset classified along two important dimensions.
For stocks and stock mutual funds (and ETFs), the vertical axis of the style box represents market capitalization and is divided into three indicators of company size: large, medium, and small. The horizontal axis varies slightly for stocks and mutual funds. The horizontal axis seeks to represent growth and value styles. The stock style box classifies individual stocks by growth, value, and core. The stock mutual fund style box classifies individual stocks by value, growth, and blend. Blend represents a combination of both value and growth.
Morningstar’s Equity Style Box
The idea of a value stock or fund is to select stocks that are selling below their real value. In other words, the stock is seen as a good value. The idea of a growth fund (or stock) is to capture the massive upside of companies that explode in value like the technology stocks for the recent past. Blended funds try to strike a balance between value and growth. Funds that are “blend” funds usually hold both value and growth stocks. The most commonly cited reason for doing this is diversification.
Morningstar’s Fixed Income Style Box
Fixed income refers to bonds and other types of instruments based on loans. The horizontal axis reflects the time to maturity that the bond (or basket of bonds held by a fund). The vertical axis represents the credit quality of the borrower. It is important to realize that the better the credit quality, the lower the interest rate the bond pays. This means that very high credit quality and short investment periods equate to very, very low returns.
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