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Course 208
Examining a Stock Fund's Portfolio, Part 2

Introduction

We've described the Morningstar style box as the "snapshot" of a fund's investment style. It's the best place to start if you're trying to uncover how a fund invests-but don't stop there. A handful of other portfolio statistics reveal additional insights into individual funds-information about a fund's risk and return potential that style boxes don't reveal.

Sector Weightings

Both Meridian Value (MVALX) and FAM Value (FAMVX) land in the mid-cap growth square of the style box, but the funds have different biases. With more than 37% of its portfolio devoted to industrials (as of December 2010), the Meridian fund is heavily exposed to the ups and downs of that sector. Meanwhile, FAM Value favors financial firms, with more than 33% of its assets in that sector as of March 2011.

Welcome to one of our favorite portfolio statistics: sector weightings. Stocks fall into one of three "super" sectors-cyclical, sensitive, and defensive-which are subdivided into sectors, bringing the total number of sectors to 11. The cyclical supersector includes the basic materials, consumer cyclical, financial services, and real estate sectors. In the sensitive supersector, there are the communication services, energy, industrials, and technology sectors. And finally, in the defensive supersector, there are the consumer defensive, health-care, and utilities sectors. Morningstar calculates a fund's sector exposure based on the amount of assets it has in stocks in each sector. By knowing how heavily a fund invests in a given sector, you'll know how vulnerable it is to a downturn in that part of the market or how much sector risk it's taking on.

Average Market Capitalization

So average market capitalization is included in Morningstar's style box calculation. But you should examine it anyway because there are small-cap funds and there are really small-cap funds.

Take Diamond Hill Small Cap (DHSCX) and Aegis Value (AVALX), for example. Both land in the small-cap value portion of the style box. But despite its small-sounding name, Diamond Hill Small Cap sports an average market cap of over $2 billion, while Aegis Value's managers consistently buy tiny firms for a portfolio with an average market cap of $317 million (as of February 2011). That's an enormous difference. That means that Aegis Value will do well against other small-value funds when micro-caps are doing well in the market. Of course, it also lags when investors get nervous and flock to larger, more established firms. Investors who aren't aware of the fund's bias might evaluate the fund as good or bad without understanding the reason behind its performance.

Conversely, there's a difference between large-cap and really large-cap funds. Vanguard Growth Index (VIGRX), for instance, carried an average market capitalization of $36.5 billion in March 2011, while William Blair Growth BGFIX clocked in at just $14.5 billion. While both are large-cap growth funds, the former fund will outperform the latter when giant-sized companies are leading the market. Conversely, the latter fund should one-up the former if smaller companies (well, small within the large-cap division) have the lead.

Price/Earnings and Price/Book Ratios

Price/earnings and price/book ratios, too, are included in the style box, but they are worthy of separate consideration. Just as there are degrees of market capitalizations, there are degrees of price multiples. Bridgeway Aggressive Investors (BRAGX) and Morgan Stanley Inst Mid Cap Growth (MPEGX) are both growth funds, but the Morgan Stanley fund's P/E ratio of 27.1 (as of March 2011) is significantly higher than the Bridgeway fund's 12.2. That means the Morgan Stanley fund courts more price risk (the risk that securities might be overvalued by the market) than Bridgeway Aggressive Investors.

Number of Holdings

It's also important to know whether a fund holds 20 or 200 stocks. You'd expect a fund with fewer stocks to be more volatile than one with hundreds of names on hand. While that isn't always the case, it often is. Just as you need to be aware of funds that place a large portion of their assets in one or two sectors, you need to know if a fund places a large portion of assets in a small number of holdings.

For example, Mosaic Midcap GTSGX and Columbia Acorn (ACRNX) are both mid-cap growth funds, yet the former generally owns less than 40 stocks while the latter stockpiles hundreds of names. Mosaic Midcap is taking on more risk-its performance is dependent on the success or failure of a much smaller number of stocks.

Turnover Rates

A fund's turnover rate represents the percentage of a fund's holdings that have changed over the past year, and it gives an idea of how long a manager holds on to a stock. Fund accountants calculate a fund's turnover rate by dividing its total sales or purchases (excluding cash), whichever is less, by its average monthly assets during the year. You can translate this math easily: A fund that trades 25% of its portfolio each year holds a stock for four years, on average.

Despite its seeming simplicity, turnover rates have their quirks. For instance, a dramatic change in the fund's asset base (the turnover ratio's denominator) can give a false impression of a fund's trading activity. If the manager doesn't change her trading pace, a fund's turnover ratio will decline as assets rise. Conversely, a shrinking asset base can inflate a fund's turnover ratio.

Turnover can give you a sense of a manager's trading activity, but don't read too much into a fund's turnover rate, particularly with bond funds. In general, buy-and-hold managers will have lower turnover rates than managers who trade on short-term factors. And generally, very high-turnover managers tend to practice aggressive strategies. With bond funds, though, quite often managers employ cash-management strategies that inflate turnover rates. It's not uncommon to see turnover rates of 300% or more, even in funds that aren't particularly aggressive.

Quiz 208
There is only one correct answer to each question.

1 Sector weightings tell you what?
a. What a fund's investment style is.
b. What industries your manager favors.
c. How much price risk a fund is taking on.
2 Price/earnings multiples tell you what?
a. How much sector risk a fund is taking on.
b. How much price risk a fund is taking on.
c. How much per-issue risk a fund is taking on.
3 A fund's number of holdings tells you what?
a. How much sector risk a fund is taking on.
b. How much price risk a fund is taking on.
c. How much per-issue risk a fund is taking on.
4 A fund's turnover rate tells you what?
a. How many managers a fund has had.
b. Whether a manager likes high-growth companies.
c. How frequently the manager trades the portfolio.
5 Which stock fund is likely the most volatile?
a. A fund with a P/E of 25, 200 holdings, and a 20% turnover rate.
b. A fund with a P/E of 30, 100 holdings, and a 50% turnover rate.
c. A fund with a P/E of 35, 25 holdings, and a 200% turnover rate.
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