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Exploring the Style Box

Phillip Gray  |  03 Jun 2008Text size  Decrease  Increase  |  

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The Style Box graphic is a way of assessing a share fund's basic market-cap and investment style characteristics. 3,520 individual funds on our database currently have Style Boxes, including unit trusts, superfunds, insurance bonds, and wholesale funds. Out of these, 3,000 are classified as large-cap share funds, 312 as mid-cap, and 208 as small-cap funds. 1,931 are blend funds, 865 as growth, and 727 as value.

We created Style Boxes as a way of helping investors and advisers check quickly and easily where a particular fund fits or would fit within a diversified portfolio. This helps avoid double-ups and overexposures to particular market-cap segments, and investment styles. Understanding a fund's investment style and market-cap profiles also helps you understand how the fund is likely to behave in the future, and how it's likely to respond to different market environments and economic conditions.

The Style Box also provides a truly fundamental indicator of whether or not a fund is 'true to label', and helps you base your portfolio construction and management decisions on more insightful factors than market reputation or fund badging, neither of which sometimes reflect the reality of the way a fund manager is really managing money, or shifts over time.

So how exactly are the Style Boxes built? What are they based on? Why do some funds' positions on the Style Box move around, and what does this mean?

Determining Fund Portfolios' Market-Caps, Styles

The Style Box has two key functions – to show where the bulk of a fund's underlying stockholdings (and therefore the fund itself) fall by market capitalisation, and by broad investment style classification.

The vertical axis on the Style Box – large, medium, or small – is a measure of the underlying stockholdings' aggregate market-cap. For the Australian market, the stocks which make up the top 70.0 percent of market-cap are classified as large-cap; the next 20.0 percent as mid-cap; and the stocks in the bottom 10.0 percent as small-cap.

The horizontal axis on the Style Box – value, blend, or growth – is a measure of the underlying stockholdings' aggregate investment style. We use 10 factors to assign an investment style to a stock. Half are value measures, and the other five are growth variables.

Half the value score is based on the stock's price to projected earnings ratio (also known as forward P/E). The other half is divided equally between the price/book, price/sales, price/cashflow, and dividend yield ratios. Lower combined valuations push a stock towards the value end of the spectrum, while higher valuations push the stock towards the growth end.

The growth score is similarly weighted: half comes from the stock's long-term projected earnings growth ratio, and the other half's divided evenly between the historical earnings growth, sales growth, cashflow growth, and book value growth ratios. Higher combined growth ratios push a stock towards the growth end of the spectrum, and lower growth rates push it towards the value end.

Within each size grouping (large-cap, mid-cap, and small-cap), we then divide stocks into broadly equal groups according to their value or growth style scores. The most value-like group gets classified as value; the middle group as core; and the most growth-like group gets classified as growth.

Plotting Market-Cap and Style

The next stage is plotting the stockholdings' market-cap and investment style characteristics on the Style Box. A fund's position is based on the asset-weighted underlying stockholdings' market-caps (for the vertical axis), and value/growth scores (for the horizontal axis).
This provides an intuitive representation of the underlying stockholdings' market-cap and style qualities. A fund which holds mostly large-cap growth stocks will fall into the large-growth square. If the fund holds stocks which lie across the value/growth spectrum, the fund will land in the blend square. And if the fund owns mainly small-cap value stocks, the fund will appear in the bottom left-hand square.

Moving Around the Style Box

From time to time, you'll see some funds move around Style Box locations. There are a couple of reasons for this.

Firstly, both stocks and funds sometimes land right on the borders between Style Box squares: for example, on the border between value and blend styles, or between mid- and small-cap sizes. Small shifts in the underlying portfolio can bump these funds between squares.

Funds can also shift Style Box locations if the fund manager changes the way they pick stocks, either in terms of the market-caps of the stocks selected, or the stocks' style characteristics. For example, a strong growth fund manager may move towards a more growth at a reasonable price style. This would alter the kinds of companies they invest in, and have a corresponding impact on their fund's Style Box location. The fund might move from being firmly in the top right-hand square (large-cap growth), to being in the top middle square (large-cap blend). Or in market-cap terms, a fund could move from being most heavily-invested in small-cap stocks, and therefore appearing in the bottom row of the Style Box, to investing more in a mixture of small- and mid-cap stocks, which could move the fund up into the middle row.

A stock can also shift if its business and valuations change, if the stock's market-cap goes up or down, and for other reasons (such as takeovers and mergers). The dividing points between value, blend, and growth classifications for stocks will also move over time, as the distribution of stock styles in the sharemarket changes.

We update a fund's Style Box whenever we get a new portfolio, sometimes as often as monthly, and we're working actively to persuade fund managers to provide us with portfolios as frequently and as accurately as possible. That way, you can have confidence that Style Boxes are based on the most recently-available portfolio holdings information.

We're not claiming that the Style Box is an instant panacea for portfolio construction, or for fund and investment strategy assessment – we continue to undertake qualitative research on fund managers' investment strategies, integrating our analysts' top-down views on the basis of interviews, visits, and analysis with bottom-up holdings-based assessments and fundamental portfolio data. The great thing about the Style Box is that it gives you a sound basis for comparing and assessing the universe of products in the market – a fundamental building block for ensuring you're building more diversified portfolios.

Phillip Gray is Morningstar's Editorial & Communications Manager. He welcomes your email but cannot offer specific portfolio advice. He can be reached at phillip.gray@morningstar.com.