Morningstar's Classification of Large-Cap Mutual Funds

Abstract

Cluster analysis of the Morningstar 500 style classifications (growth, blend, and value) of large-cap mutual funds identifies three homogeneous style groups: growth and two versions of value. The mix of Morningstar styles in each identified cluster reflects problems in correctly classifying fund style, most particularly for value and, especially, blend funds. Exhibit 5 indicates that Morningstar misclassifies only one of its 17 growth funds clustered as value(2). Assuming the least misclassification of the 35 value funds, 8 are clustered as growth and 9 as value(1). And, finally, all 31 of Morningstar blend funds are misclassified: 17 clustered as growth, 3 as value(1), and 11 as value(2).

The two value clusters (Clusters 1 and 3) are basically statistically equivalent, except for their significantly different approaches to asset allocation and security/sector diversification. Cluster 1 has the most diversified security/ sector holdings, and Cluster 3 has the most diversified asset allocation. Both value clusters and the growth cluster have statistically equivalent turnover (%) and number of securities, although Cluster 2 has the largest number.

The most interesting aspect of the analysis is that all clusters have statistically equivalent ROR-1 Year (%), ROR-3 Year (%), and ROR category rank. The same is true for worst three months ROR (%), Morningstar rating, R2, management fees (%), and sales charge (%). Thus, cluster style does not appear to be differentiated by rate of return, several Morningstar risk measures (including the star system), unsystematic risk, management fees, and sales charges. But, again, cluster style is clearly differentiated by Morningstar risk, bear market rank, systematic risk, total risk, and, most important, by the Jensen and Sharpe risk/return performance measures. These two performance measures are significantly higher for the value clusters than the growth cluster.

Overall, the more conservative risk and, especially, better risk-adjusted performance profiles of the two heterogeneous value clusters are the major factors differentiating their performance from the growth cluster (see Haslem [1988]). Morningstar's failure to recognize the different dimensions of diversification among value funds, as well as the different risk and risk-adjusted performance profiles of value and growth funds, may explain its problems in classification of fund style.

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Keywords: mutual funds, Morningstar large-cap funds, cluster analysis, value clusters, growth cluster, diversification, risk, risk/return performance

JEL Classification: G2, G23, G28