Style Box: What it is, Parameters, Limitations

What Is a Style Box?

Style boxes are a mutual fund classification scheme created by the financial analytics firm Morningstar, which are designed to visually represent the investment characteristics of stocks and mutual funds. Style boxes provide a graphical representation of investing categories for both fixed-income and equity investments. A style box is a valuable tool for investors to use when determining asset allocation. There are slightly different style boxes used for equity and fixed-income investments.

How Style Boxes Work

Style boxes are primarily used for stocks and mutual funds. They are constructed as a nine-square grid with a horizontal and vertical axis.

Stocks and Stock Funds

For stocks and stock funds the vertical axis of the style box graphs market capitalization and is divided into three company-size indicators: large, medium, and small. The horizontal axis varies slightly for stocks and mutual funds. The horizontal axis seeks to represent growth and value styles. The stock style box classifies individual stocks by growth, value, and core. The stock mutual fund style box classifies individual stocks by value, growth, and blend (which represents a combination of both value and growth). These are often referred to as the equity style box.

Together, the vertical and horizontal axes can be used to classify a mutual fund into one of nine categories:

• Large value
• Large blend
• Large growth
• Medium value
• Medium blend
• Medium growth
• Small value
• Small blend
• Small growth

This categorization system is useful in determining how an investment fits into a particular investment portfolio from an asset allocation perspective. Some investors use it to find a fund for each category while others focus on specific areas. For example, an aggressive investor might focus primarily on small-capitalization funds or growth funds. Still, a fund's placement in the style box is not only useful in selecting investments. It is also useful over the long term where historical style box data can be used to verify the consistency of a portfolio's holdings.

In addition to domestic equity funds, an international equity style box is also available as a three-by-three grid for visually representing and comparing risk-return structures of foreign stocks and foreign funds. Investors use the international equity style box, a variation on Morningstar’s stock style box, to understand the degree of diversification of their international portfolios.

Fixed-Income Funds

For bond funds, the horizontal axis shows a fund’s maturity categories represented by short-term, intermediate-term, and long-term.

A fixed-income style box is made up of nine squares with the vertical and horizontal axis used for defining investment characteristics. Morningstar uses interest-rate sensitivity and credit quality as the two primary characteristics for consideration.

On the horizontal axis, investors will find three categories for classifying interest-rate sensitivity: limited, moderate, and extensive. Interest-rate sensitivity is affected by a fund’s duration. Therefore, short-term fixed-rate funds will be found in the limited category. Long-term fixed-rate funds would fall into the extensive category.

On the vertical axis, credit quality ratings are a second factor used for classifying fixed-income fund investments. Style box credit quality categories include high, medium, and low.

Parameters for Style Box Classification

Morningstar provides a detailed breakdown of the parameters for style box quadrant classification. Interest rate sensitivity classifications are determined by a fund’s three-year average duration in comparison to the Morningstar Core Bond Index.

Credit quality is determined by a methodology involving weighted average credit ratings of a fund. Funds in the high credit quality box will have an asset-weighted average credit rating of AA- and higher. Funds in the low credit quality box will have an asset-weighted average credit rating of less than BBB-. Morningstar is the primary developer of fixed-income style boxes. However, variations do exist from other financial information providers.

Style Box Analysis

While Morningstar is the primary source for style box analysis, technology across the industry can produce various style box representations. A style box can help investors better understand the qualities and characteristics of an investment. An investor can also use style box analysis to build a diversified portfolio of investments across categories.

For example, an investor looking for a relatively safe stock fund as a more conservative investment for the equity portion of their portfolio could seek something in the large-cap value box, since large-cap earnings are generally stable and value funds are good for long-term holdings. If that same investor is looking for something with more risk and greater return to add to the more aggressive portion of their portfolio, then they might want to select a fund in the small-cap growth category.

Morningstar allows investors to filter funds by the style box category. While the style box category provides a guide for investment, investors should also do careful due diligence to ensure a fund meets their investing interests. Morningstar analyzes stocks and funds by style box category for investments from around the world. Their style box rankings include both domestic and international investments with risk characteristics ranging broadly across the investment universe.

Limitations of the International Equity Style Box

Morningstar introduced its proprietary style box in 1992. Its simple, effective visual classification system soon made it ubiquitous in the investment world. Its simplicity and ubiquity remain two strong reasons to continue to use the style box in its several forms, but it has its limitations.

For one, the style box does not include short positions in its classification system. That means a long-short investment strategy can’t be represented in the style box. Some other strategies are not committed to consistent growth, value, or blend approaches. Investment products managed by these strategies will bounce all over the style box as the nature of their holdings shifts along the horizontal axis.

Some analysts have speculated that the popularity of the style box unduly restricts fund managers who may avoid certain sound investment strategies because they would cause the fund to change categories in the style box. This, in turn, may frustrate shareholders who bought into the fund partly because of its style box classification.