Morningstar’s Style Box is Adrift; That’s a Problem

Morningstar’s Style Box is Adrift; That’s a Problem

The iconic investing tool, familiar to millions, has lost some of its usefulness.

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Reviewed by: etf.com Staff
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Edited by: Ron Day

Perhaps one of the most valuable tools ever invented to analyze portfolios and funds is the trademarked nine-square Morningstar Style Box. The equity style box categorizes stocks and stock funds. On the vertical axis, there are three categories that represent market capitalization: small, mid, and large caps. On the horizontal axis, there are value, blend, and growth categories. This three-by-three grid creates nine distinct categories that represent a portfolio’s investment style. 

 Chart 1 

How adrift is it? Since last year, Morningstar considers the the iShares Core S&P Total US Stock Mkt ETF (ITOT) a large cap growth fund. 

Chart1

The same goes for cap weighted Vanguard Total Stock Market ETF (VTI).

I understand that the market is dominated by large cap companies but it’s illogical that the total stock market could be anything other than a blend of value, core, and growth. Contributor and author William Bernstein told me: “I'm bemused by VTI's growth-lean on the style box; why isn't it smack in the middle of the value-growth axis.” I concur.  

Why is this a problem? Like many others, I use the style box to evaluate and monitor portfolios for style drift. But when the benchmark drifts, the value of monitoring and evaluating is diminished. I’ve been pointing this out to Morningstar for some time.

Then and Now

The original Morningstar style box was developed in 1992 by managing director Don Phillips and vice president of research, John Rekenthaler. I know both and have the upmost respect for their analytical skills and dedication to helping investors. Before the style box, managers in a riskier small cap value style were claiming to be brilliant stock pickers until Morningstar began comparing to the style of investments most similar to their portfolios. It was like opening the curtain and letting the sunlight shine in.  

The style box was set up to be 70% large-cap, 20% mid-cap, and 10% small-cap with a third each in value, blend, and growth. The change is especially huge in large-cap growth which now includes nearly 35% of the entire U.S. stock market capitalization. In fact that’s more than style drift—it’s a seismic shift. Don’t get me wrong, the style box benchmarking is still useful but not as valuable as it once was. 

  

The problem is that comparing portfolios over time could lead to incorrect conclusions that a manager has changed their style. A change over time could be either because the manager changed her holdings or because the style box shifted, or a combination. A total stock portfolio has not shifted over time since it owns the entire market with a market cap weighting.

Good News on the Horizon

While I’ve had some informal conversation with Morningstar personnel, I decided to reach out to Morningstar for an official response. A Morningstar spokesperson told me, “We are aware of the issue and our research methodology team is working on an update.”  

She told me Jeffrey Ptak, Chief ratings officer at Morningstar Research Services LLC, pointed out that there is a difference between the style box and the Morningstar Category, as the style box is a snapshot in time while the category classification is based on a three-year lookback, reflecting more long-term style traits. Investors should use both tools to form a complete picture of a fund’s stylistic traits. Indeed, Morningstar compares the performance of both VTI and ITOT against the Morningstar US Large-Mid Cap Index but that would likely change if they stayed in the large growth style box for more than half of the past three years.  

The Morningstar spokesperson told me the correlations of returns to assigned peer group averages remains high in spite of the skewing toward growth. Yet correlations can be high while the magnitudes of returns can be quite different. This can be seen by U.S. and international stocks being highly correlated but U.S. stock returns trouncing international.  

Conclusion: The Box has Shifted

Morningstar has done so much to help investors over the past 40 years and their accomplishments are epic. I’m thrilled they are working on this issue. It’s a whole lot easier for me to point out a problem than to actually fix it.  

For now, just be aware that the Morningstar style box has shifted. It will likely shift back to its original relative weightings once the issue has been addressed. The stock market isn’t concentrated on growth or value—it has a relative weighting on both and represents the combined knowledge of hundreds of millions of investors. 

Allan Roth is founder of Wealth Logic, an hourly based financial planning and investment advisory firm. He also benchmarks portfolio performance for foundations and other business concerns. Roth's website is www.DareToBeDull.com. You can reach him at [email protected] or follow him on Twitter at Allan Roth (@Dull_Investing) · Twitter