Source: Flickr

The style box is a way to visual certain characteristics of a bond, stock and the funds that hold them. It was created by Morningstar to help investors and advisors determine the investment style of a fund. Here, we’ll explore how the style box is used for its original purpose, analysing funds. (Bonds and stocks have slightly different style boxes, but the principles behind them are largely the same.)

How it works

The style box is a nine-square grid that categorises securities by size (along the vertical axis) and by value/growth characteristics (along the horizontal axis). A fund is evaluated based on the portfolio of securities it holds. So each security is placed in the style box. Once all securities have been categorised, their attributes are ‘rolled up’ to determine the overall style of the fund.

Source: Investopedia

Company size

The size of a company is calculated using market capitalisation (number of shares outstanding x share price). There are no exact definitions of ‘market caps’, but the general rule of thumb is as follows:

Large cap: over £10bn

Mid cap: £2bn to £10bn

Small cap: Below £2bn

Why is it good to know a company’s size? In investment circles, it is widely believed that the company size and its risk are related. Although there are exceptions, large companies are perceived as safer while small companies are seen as riskier. It’s worth noting that it is also widely believed that risk and return are related: the lower the risk, the lower the return. As a result, investors should expect higher returns from smaller companies and less spectacular returns from large companies.

Value/growth characteristics

There are three broad equity investment styles for funds: value, growth and blend (a mix of value and growth strategies). Funds with a value investing style tend to invest in value stocks; those with growth investing style will mostly invest in growth stocks.

A blend investing style is a mix of value and growth stocks.

As a refresher, growth stocks are those whose earnings are expected to grow faster than the market. They usually don’t pay any dividends; instead, the company reinvests earnings into its expansion. A good example of growth stocks would be most technology companies.

So a fund with a growth investing style tends to have above average risk since not all growth companies will outpace the market and succeed (e.g. the tech bubble). Investors in a growth investing fund should also not expect high dividend yields (if any).

A value stock, on the other hand, is a stock which the investor believes to be undervalued. Such investors (called value investors) take the stance that the market can be inefficient and hence fail to recognise a company’s good prospects. This leads to some companies being traded for less than their worth. Common characteristics of value stocks include high dividend yields, low price-to-book ratios and low price-to-earnings ratio.

A fund with a value investing style tends to have low risk. Value stocks are unpopular; the market is not as excited about them as it is about growth stocks. The key is to understand why they are unpopular – are they unpopular because the company has fundamental problems and can go bust, or is it because the market is simply not very interested or excited about it? You would hope that it’s the latter. It may take years (even decades, but sometimes never) for the market to come round to a value investor’s point of view. If this happens, there could be fantastic rewards at the end of a long and modest road.

Value investing involves waiting for the market to come round to your point of view.

Why bother

Why is knowing a fund’s investment style important anyway? Three main reasons:

When building an investment portfolio, knowing a fund’s style will stop you from putting all of your eggs into one basket (e.g. investing only in small-cap growth funds). In other words, it helps to diversify the risk and return of your portfolio.

It also helps avoid duplication in investment categories. If you already invest in a small-cap growth fund, do you really need to invest in another one since they will probably overlap in what they invest? Having another small-cap growth fund may not add anything (higher return nor diversification) to your portfolio.