Question: I recently noticed that Morningstar put a fund with "small-cap" in its name into a mid-cap category. Is this a mistake?
Answer: Investors naturally expect that a fund with "small-cap" in the name will fall into one of Morningstar's small-cap categories, and most do. However, in rare instances a fund's name and its category will not match.
For example, Longleaf Partners Small-Cap (LLSCX), despite its name, falls within the mid-blend category. A look at its most recent portfolio disclosure, from June 30, shows that at the time 48% of its holdings consisted of small- and micro-cap stocks (defined by Morningstar as those in the bottom 10% of capitalization among U.S. equities), with 45% landing in mid-cap range (the next biggest 20% of stocks) and another 8% in large caps (the 70% biggest). Although the fund holds a large percentage of stocks in small-cap range, it holds even more that are larger, according to Morningstar's market cap guidelines. Yet even this doesn't fully explain why the fund is considered a mid-cap fund.
Category Assignments Based on Historic Holdings
To better understand why a fund's name and category may not match, let's look at how Morningstar assigns funds to categories. Category assignments generally are based on the fund's average holdings during the previous three years (with new funds assigned to the category deemed most suitable). So a fund that typically holds mostly large-cap stocks but which recently has ventured more heavily into mid-cap territory most likely will remain in the large-cap category, at least for now. On the other hand, a fund that demonstrates a long-term shift in the nature of its holdings might switch categories. In fact, Longleaf Partners Small-Cap resided in the small-value category before joining mid-value in 2009 and then switching to mid-blend in 2011.
Other funds that currently have name-category mismatches include Guggenheim Mid Cap Value (SEVAX) (in the small-value category), Dreyfus Small Cap Equity (mid-blend category) (DSEAX), and Stratton Mid Cap Value (STRGX) (large-blend category). This isn't to say that any of these funds aren't doing their jobs well. Rather it means that, based on their holdings over time, Morningstar feels they are better fits in categories other than those suggested by their names.
Keep in mind that category assignments are rather important because Morningstar uses them to rank funds by performance, determine a fund's Morningstar Risk rating, and calculate other metrics designed to compare funds with those that have similar characteristics. Moving funds in and out of categories frequently would make such apples-to-apples comparisons difficult. (To read about how a category change affects fund performance data, read this previous Short Answer article (http://news.morningstar.com/articlenet/article.aspx?id=579626).)
How Category-Style Box Mismatches Occur
Another common area of confusion involves a fund's Morningstar Style Box assignment and its Morningstar category, which are occasionally mismatched. For example, a fund in the large-blend category may fall into the large-value corner of the box if its managers have been tilting the portfolio toward more stocks that are considered underpriced. But unlike the category assignment, which is based on holdings over time, the style-box assignment reflects only the fund's current holdings and is based on an asset-weighted calculation of all the stocks in the portfolio. (For more on discrepancies between the style box and category, read this article (http://news.morningstar.com/articlenet/article.aspx?id=306244).)
One way to think of the distinction between a fund's style-box and category assignments is that the style box represents a snapshot of what the fund's portfolio looks like now whereas its category represents a big-picture view of its long-term strategy. If they see opportunities, a fund's managers might tactically dip more heavily into stocks they would normally shy away from, but that doesn't necessarily mean their overall strategy has changed. (Incidentally, you can see a fund's style history by going to its Quote page on Morningstar.com, clicking on the Portfolio tab, and looking in the right-hand column under the Style Details section.) However, if the fund's investment style differs from its category assignment for a long period of time, or if events such as a name and/or prospectus change occur, Morningstar analysts might move the fund to a different category.
SEC Naming Rules Far From Air-Tight
Mutual fund companies are bound by SEC rules that require that they invest at least 80% of assets in investment types that are suggested by their names. A fund with a name that implies it invests mainly in stocks can't invest more than 20% of assets in bonds, a fund with a name that implies it invests mainly in foreign equities can't invest more than 20% of assets in U.S. stocks, and so on. However, the SEC rule doesn't codify everything. For example, the word "income" in a fund's name implies a given strategy rather than an investment type, so the rule doesn't apply. (Click here (http://news.morningstar.com/articlenet/article.aspx?id=368551) for a look at "income" funds that don't live up to their names.) The SEC also doesn't specify what constitutes small-, mid-, and large-cap stocks, instead requiring that fund companies "use any reasonable definition of these terms" and define them in their prospectuses. For more on these and other SEC fund-naming rules, click here (http://www.sec.gov/divisions/investment/guidance/rule35d-1faq.htm).
Have a personal finance question you'd like answered? Send it toTheShortAnswer@morningstar.com.
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