Domestic-Equity Style Box

The equity style box is a nine-box matrix that displays both the fund's investment methodology and the size of the companies in which it invests. Combining these two variables offers a broad view of a fund's holdings and risk.

The style box for domestic-stock funds comprises two components: market capitalization on the vertical axis and valuation on the horizontal axis.

• Market Capitalization
  Morningstar ties market cap to the relative movements of the market. The top 5% of the 5,000 largest domestic stocks in Morningstar's equity database are classified as large cap, the next 15% of the 5,000 are medium cap, and the remaining 80% (as well as companies that fall outside the largest 5000) are small cap. Morningstar then determines a fund's market cap by ranking the stocks in a fund's portfolio from the largest market-capitalized stock to the smallest, and then calculating the average weighted market capitalization of the stocks in the middle quintile of the portfolio. After a fund's market cap has been determined, Morningstar places the fund in the large-cap, medium-cap, or small-cap group (noted above).
• Valuation
  Morningstar categorizes funds by comparing the stocks in their portfolios with the most relevant of the three market-cap groups. Specifically, each stock in our equities database receives a price/earnings score and a price/book score. This is derived by dividing each stock's P/E and P/B by the asset-weighted median P/E and asset-weighted median P/B (respectively) of the stock's market-cap group. For example, to calculate the asset-weighted median P/E, we first rank the P/E ratios of the stocks in each market-cap group from highest to lowest, then count down by their market caps until we reach the 50th percentile of that market-cap group. The P/E ratio attached to that stock is the asset-weighted median P/E of that market-cap group. We do the same to find the asset-weighted median P/B. (We do not calculate these figures for international stocks.)
  Next, we calculate the P/E valuation score and the P/B valuation score for each fund by ranking the stocks in a fund's portfolio by their median market caps and then calculating an average weighted P/E score and an average weighted P/B score from the stocks in the middle quintile of each fund's portfolio. (International stocks are again not included in this calculation.) These average weighted scores are the P/E valuation score and the P/B valuation score of the fund's portfolio. For each measure, 1.00 represents the market-cap group average. If the fund has a combined P/E score and P/B score that exceeds 2.25, the fund is categorized as growth. If the combined score is less than or equal to 2.25 but greater than or equal to 1.75, the fund is categorized as blend. Finally, if the score is less than 1.75, the fund is categorized as value. Generally speaking, a growth-oriented portfolio mostly contains companies that its portfolio manager believes have the potential to increase earnings faster than the rest of the market. A value orientation, on the other hand, focuses on stocks that the manager thinks are currently undervalued in price and believes will eventually see their worth recognized by the market. A blend fund mixes the two philosophies: The portfolio might contain growth stocks and value stocks, or it might contain stocks that exhibit both characteristics.

International-Equity Style Box

Investment-style data are computed differently for international-equity funds than they are for domestic-equity funds. On the vertical axis of the style box, international-stock funds are grouped as small, medium, and large. Funds with medium market capitalizations of less than $1 billion are small cap; funds with median market caps equal to or greater than $1 billion but less than or equal to $5 billion are medium cap; and funds with median market caps greater than $5 billion are large cap.

On the horizontal axis, international-stock funds are separated into value, blend, and growth. Because earnings are reported in different ways in other regions, Morningstar uses price/cash flow, rather than price/earnings, for international investment-style data. Cash flow from operations takes into account net income and adds back all the adjustments that earnings accounting can make for non-cash expenses—such as depreciation and the use of reserve accounts—and subtracts out all cash payments. International funds' price/cash flow and price/book ratios are viewed in relation to the MSCI Europe Australia Far East index, rather than against the domestic S&P 500 index.

We take the stock portfolio's average price/cash-flow ratio relative to the MSCI EAFE index and add it to the portfolio's average price/book figure relative to the MSCI EAFE index. (The MSCI EAFE average in each case is set equal to 1.00.) If the sum of the relative price/cash flow and the relative price/book is less than 1.75, the fund is defined as a value offering; if the sum lands from 1.75 to 2.25, the fund is classified as blend; and if the sum is greater than 2.25, the funds falls into the growth column.

Fixed-Income Style Box

Domestic and international fixed-income funds focus on the two pillars of fixed-income performance: interest-rate sensitivity and credit quality. Morningstar splits fixed-income funds into three groups of rate sensitivity as determined by duration (short, intermediate, and long) and three credit-quality groups (high, medium, and low). These groupings graphically display a portfolio's average effective duration and credit quality. As with equity funds, nine possible combinations exist, ranging from short maturity/high quality for the safest funds to long maturity/low quality for the more volatile.

Along the horizontal axis of the style box lies the average term length of a fund's bond portfolio based on average effective duration. This figure, which is calculated by the fund companies, weights each bond's duration by its relative size within the portfolio. Duration provides a more accurate description of a bond's true interest-rate sensitivity than does maturity because it takes into consideration all mortgage prepayments, puts, and adjustable coupons. Funds with an average effective maturity of less than 3.5 years qualify as short term. Funds with bonds that have an average effective duration greater than or equal to 3.5 years but less than or equal to six years are categorized as intermediate, and those with maturity that exceeds six years are long term. (The duration ranges vary slightly for municipal-bond funds: Less than 4.5 years is short term; 4.5 to seven years is intermediate; and greater than seven years is long term.)

If duration data are not available, Morningstar uses average effective maturity figures to calculate the fund's style box. Although duration is the more accurate measurement, maturity can also be used to gauge the amount of interest-rate risk in a fund's portfolio. Funds with bonds that have an average effective maturity of less than four years qualify as short term. Funds with an average effective maturity greater than or equal to four years but less than or equal to 10 years are categorized as intermediate, and those with maturity that exceeds 10 years are long term.

Along the vertical axis of a fixed-income style box lies the average quality rating of a bond portfolio. Funds that have an average credit rating of AAA or AA are categorized as high quality. Bond portfolios with average ratings of A or BBB are medium quality, and those rated below BB are categorized as low quality. For the purposes of Morningstar's calculations, U.S. government securities are considered AAA bonds, nonrated municipal bonds generally are classified as BB, and all other nonrated bonds are considered B.

• Average Credit Quality
  Average credit quality gives a snapshot of the portfolio's overall credit quality. It is an average of each bond's credit rating, weighted by the relative size in the portfolio. For the purpose of Morningstar's calculations, U.S. government securities are considered AAA bonds, nonrated municipal bonds generally are classified as BB, and other nonrated bonds generally are considered B.
• Average Effective Duration
  Average effective duration provides a measure of a fund's interest-rate sensitivity—the longer a fund's duration, the more sensitive the fund is to shifts in interest rates. The relationship between funds with different durations is straightforward: A fund with a duration of 10 years is twice as volatile as a fund with a five-year duration. Duration also gives an indication of how a fund's NAV will change as interest rates change. A fund with a five-year duration would be expected to lose 5% from its NAV if interest rates rose by one percentage point or gain 5% if interest rates fell by one percentage point.

Hybrid Funds

For hybrid funds, both equity and fixed-income style boxes appear.