Use the MF style box to determine overall asset allocation

Mutual Funds have become a fairly common instrument for investment today. Investors are realising that to create long term wealth they need to have equity in their portfolios to beat inflation. As compared to direct equity, MFs are more appropriate option for first time investor. On fixed income instruments side, too, debt MFs score over fixed deposits.

However, once the decision is taken to invest into MF, it is imperative to understand how to choose a fund. There are multiple ratios, graphs and tools available to understand about the funds. One of the easiest and most common tool to understand about MF portfolio is its style box.

The MF style box is a nine square grid box that provides the graphical representation of the fund manager's investment style. The style box helps in informed comparison and fund selection based on actual holdings, as opposed to assumptions based on fund's name or how it is marketed.

Equity MF style box:

The style box classifies securities according to market capitalisation on vertical axis and growth and value factors on horizontal axis. Market capitalisation on the vertical axis is divided into three capitalisation or categorisation bands, that is, large, mid and small. Horizontal axis is divided between growth, value and blend.

A growth-oriented fund will hold stocks of companies that the portfolio manager believes will increase earnings faster than the rest of the market. A value-oriented fund contains mostly stocks the fund manager thinks are currently undervalued in price and will eventually see their worth recognized by the market. A blend fund might be a mix of growth stocks and value stocks, or it may contain stocks that exhibit both characteristics. Understanding how different types of stocks behave is crucial for building a diversified, style-controlled portfolio of stocks or mutual funds. For example below is an example of the style box of Kotak Standard Multicap.

As seen in the above grid Kotak Standard Multicap is placed in the third column in first, as it is a large-cap growth-oriented fund.

Fixed income style box:

The model for the fixed income style box is based on the two pillars of fixed-income performance: interest-rate sensitivity and credit quality. As depicted in the image below, the three interest sensitivity groups are limited, moderate and extensive and the three credit quality groups are high, medium and low. These groupings display a portfolio's effective duration and third party credit ratings to provide an overall representation of the fund's risk orientation given the sensitivity to interest rate and credit rating of bonds in the portfolio.

The horizontal axis focuses on interest-rate sensitivity as measured by the bond's portfolio effective duration. The vertical axis focuses on the credit quality of the fund. The industry practice of reporting the average credit rating of a bond portfolio by taking a weighted average of ratings based on data provided by the fund company. However, because the default rates increase at an increasing rate between grades (a mathematical property called convexity), this method systematically understated the average default rate of a bond portfolio.

The credit quality on vertical axis is categorised as below:

Low credit quality – where asset weighted average credit rating is less than BBB-Medium credit quality – where asset weighted average credit rating is less than AA-but greater or equal to BBB-High credit quality – where asset weighted average credit rating is AA- and higher

Investors should assess their investment horizon and risk taking ability and accordingly choose the funds. While selecting equity funds, individuals with low risk taking willingness should favour funds with large-cap holding and blend portfolio. An aggressive investor can look at mid-and small-Cap with growth oriented portfolio. During selection of debt funds individuals with small time frame should look at limited interest rate sensitivity and medium credit quality. In current interest rate hike scenario, investors should enter in limited interest rate sensitivity and high to medium credit quality funds.

MF box is a simple and highly useful tool that continues to play a key role in investment evaluation and you can use a style box to review different types of mutual funds. The MF style box can also help you determine the overall asset allocation of your portfolio.

The writer is head - products, Anand Rathi Preferred