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Diversifying Your Mutual Fund Portfolio

By Jane Bryant Quinn
Thursday, November 7, 1996


NEW YORK -- By now, all serious investors know that they ought to diversify their mutual-fund holdings. But what does diversification mean?

It doesn't mean owning four different growth funds -- which is probably the average stock investor's most common failing. When growth-stock investing falls out of fashion, as it does from time to time, all those funds will stall together.

To be properly diversified, you need funds with different investment styles. That might mean one growth fund that buys big-company stocks, one that buys smaller companies, one value-stock fund (value stocks are relatively lower-priced), and one fund with international holdings.

That way, you have something going in almost any market climate. When growth stocks lag, your value stocks should charge ahead.

But building a diversified portfolio is easier said than done. A fund's name may not reflect the types of stocks it contains. A manager may switch styles. The fund's objective, as stated in the prospectus, may be hopelessly vague.

For example, what, exactly, is a "capital appreciation" fund or a "growth and income" fund? Very different types of funds may claim the same investment objective. We need better definitions, to help us tell one type of fund from another.

A new move by Morningstar, a mutual-fund research firm in Chicago, should advance this cause.

Morningstar tracks mutual-fund performance. It awards stars to the best performers in four large fund groups -- U.S. equity, international equity, taxable bond and municipal bond.

Starting this month, Morningstar will unveil a second rating system. Mutual funds will be grouped into 44 categories, according to their investment styles -- for example, big-company growth funds, small-company growth funds, utility funds, Europe funds, long-term municipal bond funds, intermediate-term taxable bonds and so on.

The best performers in each group will get "category ratings" based on the past three years of risk-adjusted data. The top 10 percent of the funds in each group will get a "category five" rating, second-tier funds get a "category four" and so on.

This supplements Morningstar's star-rating system, which will coexist with the new category ratings.

Morningstar decides for itself what category a fund belongs to, based on the investments it holds. Benham Equity Growth Fund, for example, is classified as a big-company value fund, not a growth fund, says Morningstar's Amy Arnott. Dean Witter American Value has a growth-fund investment style.

At first, investors will find these new categories only in Morningstar's own software and publications, such as its monthly mutual-fund newsletter "Morningstar Investor" ($79 a year; call 800-735-0700). Eventually, newspapers and on-line services that use Morningstar data may decide to publish the categories, too, Morningstar publisher John Reckenthaler told my associate, Kate O'Brien Ahlers.

You can also count on the funds with high ratings under the new category system to advertise that fact immediately. The ads should direct your attention to each mutual fund's style, rather than to woozy definitions like "aggressive growth."

One warning about Morningstar ratings, both the stars and the new category ratings: they reflect past performance only. You can't rely on them to predict the future. A three-star fund may be ready to rise while a five-star fund could be due for a pause.

The ratings, however, do steer you away from funds whose total returns have fallen well below average.

If you own several mutual funds, take a look at their investment style to see if you're diversified enough. You need small stocks and large stocks, value and growth investment styles, and some international holdings. Here's part of Morningstar's guide to evaluating stock funds:

What size companies does your fund buy? Size is gauged by a company's "market capitalization" -- that's the current price per share times the number of stocks outstanding. In a big-stock fund, stocks should have a median market capitalization of $5 billion or more. A small-cap fund would be under $1 billion. Mid-cap is anything in between.

What type of stocks does your fund manager like? If the manager buys relatively higher-priced stocks, with a high price to earnings ratio, you're in a growth fund. If he or she trolls for cheaper stocks with low P/E ratios, you're in a value fund.

How international are your holdings? A "foreign" fund is 90 percent invested outside the United States. A "world" fund is at least 40 percent invested abroad.

Jane Bryant Quinn welcomes letters on money issues and problems but cannot offer individual financial advice.

© Copyright 1996 Washington Post Writer's Group

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