Boxes to Be Handled With Care

To the people who love them, style boxes are great diversification tools. Bob Olstein is not one of those people.

“Those boxes are artificial barriers, and somebody should rip them up,” says Olstein, manager of top-performing Olstein Financial Alert. “If a guy wants to only buy small companies, that's fine — but he should compete against people who buy anything.”

Olstein's view is unusually intense, but he is hardly alone in grumbling about the boxes devised by Morningstar and other fund raters. Portfolio managers complain that purists restrict them, forcing funds to buy stocks they don't really want. Financial advisors worry that the boxes may provide misleading guidance.

How Did I Get Here?

On balance, few advisors agree with the antibox sentiments. When they were first introduced in the 1980s, the style categories represented an important advance. Before then, all equity funds were lumped together. An advisor who bought three top-performing funds might have purchased choices that all rose and fell at the same time. The advent of the style boxes made it easier to diversify.

From the beginning, Morningstar held the boxes up only as rough guides. But problems have appeared because some take the idea of style investing to extremes. For instance, clients sometimes insist on holding funds in each of the nine equity boxes. Then there are the shareholders who are too quick to pull the trigger, dumping value funds the first time the funds buy a few traditional growth stocks. For advisors, the challenge is to use the style boxes sensibly — while recognizing their limitations.

To make the best use of the boxes, it is important to understand that the lines between categories are not always clearly defined. The same stock can appear in both a growth and value index. In calculating its benchmarks, for instance, Frank Russell divides the investment universe into growth and value, based on valuation and prospective earnings growth. About one-third of all stocks are considered pure value, and another third are growth. But there is a middle third that has both characteristics. This uncertain group has some representation in both the Russell 1000 Growth Index and the 1000 Value Index. In 2003, Agilent Technologies appeared in both benchmarks, and the stock was listed among the top 10 performers for the year in both growth and value groups.

Just as individual stocks might have a mix of characteristics, most funds have several different traits. Many large-cap funds also own some mid-caps.

“Most funds migrate through styles a bit, and that is all right,” says Roger Ibbotson, chairman of investment researcher Ibbotson Associates.

Wondering About Wandering

When is a little drift too much? Faced with murkiness, advisors often need to make hard judgments. Many purists insist on as much consistency as possible, maintaining, for example, that it is acceptable for a small-cap fund to buy a few mid-cap stocks — provided the fund did that consistently in the past. But if a small-cap fund suddenly begins buying a lot of mid-caps, then it is time to sell the holding.

Some advisors aim to find a middle ground.

“We demand style consistency, but we are not as pure as the driven snow,” says John P. Sterba, chairman of Investment Management Advisors, a registered investment advisor in New York.

During uncertain market conditions, Sterba buys a fund or two that is known to drift. He relies on top managers of these funds to pick the right sectors and provide diversification. Recently he started buying Pioneer Strategic Income, a fund that has freedom to buy a variety of bonds, including foreign and high yield issues. Those securities could thrive if interest rates rise and investment-grade bonds sink. Sterba has also bought Hussman Strategic Growth, a fund that can raise or lower its stock allocation.

Top managers should be given freedom to wander, says Steve Savage, managing director of Advisorintelligence.com, an online service for financial advisors. While it is important to design appropriate allocations for each client, advisors should recognize that they have limited ability to boost returns by fine-tuning.

“If you are spending a lot of time worrying about whether you should put 3 percent or 4 percent of assets into emerging markets, then you are probably not adding much value,” says Savage. “You may do better by hiring a talented international manager and allowing him a bit of leeway to set regional asset allocations.”

For each of his clients, Savage starts by breaking the domestic allocation into four rough segments, large value and growth, and small value and growth. Then he makes rough allocations for each segment. If an allocation exceeds its target by 5 percent, then Savage considers whether the holding needs rebalancing. Within his guidelines, he gives managers room to practice their discipline. His favorite managers include such wide-ranging stock pickers as Bill Miller of Legg Mason Value and Bill Nygren of Oakmark.

Morningstar lists Miller in the large-cap blend category, but that hardly describes what he does. Legg Mason looks for undervalued stocks. The list of holdings includes deep value names, such as Eastman Kodak, which appears to face serious problems. The portfolio also holds fast growers — such as eBay and Amazon. Miller says that his highfliers are undervalued because they are poised to grow much faster than what the market suspects. Nygren, who falls in the large-value box, buys undervalued names. But like Miller, he picks an unusual mix, including fallen growth stocks like Home Depot and Time Warner.

While both Nygren and Miller can increase a portfolio's returns, advisors must use them carefully, watching to see whether the free-ranging choices throw off asset allocations. One problem is that the two funds often hold the same names. Of Legg Mason's top 20 holdings, five also appear in the top 20 names of Oakmark. Many advisors would consider that excessive duplication and be forced to dump one of the funds.

Advisors must be particularly careful to monitor a wide-ranging fund like Muhlenkamp, a top performer. Portfolio manager Ron Muhlenkamp buys stocks of all sizes. When all the holdings are averaged, the fund lands in the Morningstar mid-cap box. The fund is considered a value specialist, and it does have a price/earnings ratio of about 10, well below the figure for the S&P 500. But the long-term earnings growth rate of the holdings is 25.8 percent, more than double the figure for the S&P. “If you pay attention to the style box, you won't learn much about our fund,” says Muhlenkamp.

Because it is so hard to categorize, some advisors avoid funds like Muhlenkamp. But others prefer a middle ground, including one or two wide-ranging funds and filling the rest of the portfolio with pure plays. That way, the client can benefit from the top returns of an eccentric choice, and the advisor can still keep some rough control over asset allocations.

Out of the Box