Morningstar Advisor - Winter 2008 - 96

The Phillips Curve The Style Counsel By Don Phillips I sketched out the plans for the Morningstar Style Box while returning from the ICFP Retreat in Rhode Island in the early 1990s. The style box was inspired by a talk that Pennsylvania Mutual’s Tom Ebright gave, in which he described the process of building a portfolio of funds as similar to that of constructing a baseball team. Tom advocated assembling a balanced set of skills, rather than having a team made up exclusively of home-run hitters or base stealers. He drew a four-box grid showing how funds could invest in large or small, growth or value strategies. When we expanded that grid to nine boxes and introduced it in Morningstar Mutual Funds, Tom was kind enough to send a note saying that we’d built a better mousetrap. I saw the style box as a useful tool to help describe a fund’s characteristics—a means of synthesizing all of the embedded data in a fund’s portfolio holdings into a simple metric that investors could use to better place a fund in their portfolio lineup. In a sense, we wanted a fund investor to be able to visualize what a rival fund manager could ascertain by looking at a list of holdings. We never envisioned that the style box would be used as a means of policing fund managers or would serve as a road map for product development by legitimizing nine distinct types of diversified domesticstock funds. But then, any idea’s potential for popularity is directly correlated to its potential for misuse—the more ways you can use a tool, whether intended or not, the broader the number of people who will embrace it. Of late, it’s become fashionable to criticize the style box for fencing managers in and limiting their choices. While academic research shows that added discipline leads to better, not worse, results, the romantic notion that if given more space managers could produce better results holds much appeal—and in a handful of cases with gifted managers it’s almost certainly true. But before jettisoning the style box, consider the benefits that the style box brings. Style boxes bring clarity to fund naming. Before the style box, fund names were often ambiguous or misleading. We’d talk to a self-described “growth” manager one day who spoke of buying IBM and Coca-Cola. We’d then speak to an avowed “value” manager who was buying the same stocks. The managers weren’t necessarily trying to mislead anyone; they just had different definitions of growth and value. There was little industry agreement on just what these terms meant. Differing definitions are fine for encouraging debate, but they easily confuse investors. Taken to extremes, industry names ventured from confusing to downright misleading. For example, both T. Rowe Price and Fidelity ran “blue-chip” stock funds in the early 1990s. T. Rowe’s blue-chip fund took a conventional definition of the term and held giant firms. Fidelity’s fund held much smaller companies that manager Michael Gordon confessed were probably better thought of as “future blue chips.” How were investors to know the difference if they couldn’t see the large-blend box for T. Rowe’s fund and the mid-growth box for Fidelity’s? Style boxes help show where a fund fits in a portfolio by illustrating which funds are complementary and which overlap. Where does a fund with a name like Magellan, Mercury, or Windsor fit in a portfolio? Does a portfolio tilt toward growth or toward value? Does it have sufficient small-cap exposure? Without the style box, or better yet our Ownership Zones, it’s hard for investors to tell. Even worse, when undefined funds are evaluated together, those that favor a certain style will rally at the same time and dominate the much-trumpeted leader’s lists. An investor assembling a portfolio using these lists will get a set of similar funds, not a welldiversified portfolio. Style boxes help combat this problem and aid diversification. Finally, and most importantly, style boxes shift power from those who manufacture funds to those who purchase them. Fund companies, naturally, want more control over how their offerings are evaluated—and if at all possible to stack the odds in their favor. Shareholders and financial advisors understandably want to know that a fund actually does what it says it is doing. Before the style box, fund categorizations were based largely on what fund companies said the fund’s objective was. As public recognition and manager bonuses hinged on a fund’s performance within its category, there was predictably lots of gamesmanship on the part of funds to obtain the category placement that would most flatter the fund. As we said at the time, the easiest way for a fund to be number one in its category was for it to be miscategorized. Style boxes took the process out of the hands of fund sellers and allowed for cleaner comparisons to the benefit of fund buyers—a significant step forward for investors, but a loss of control for marketers. Yes, style boxes can be interpreted in counterproductive ways, but the benefits to investors should not be tossed aside too readily. Returning to an era in which funds were routinely misclassified and difficult to place into a portfolio would hardly be a better solution. Like any useful tool, style boxes can be a great helper if deployed skillfully. They give investors and their advisors a valuable lens through which to view the wide array of choices that confront them. K Don Phillips is Morningstar’s managing director, corporate strategy, research, and communications. 96 Morningstar Advisor Winter 2008

Morningstar Advisor - Winter 2008

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