UNDERSTANDING MUTUAL FUNDS RETURNS ACROSS MORNINGSTAR STYLE BOXES

ABSTRACT

This study offers a thorough examination of mutual fund performance from 2010 to 2023, across various fund categories, by employing the Morningstar Style Box to categorize funds into Growth, Blend, and Value within Large, Mid-Cap, and Small fund segments. The analysis utilizes the Sharpe ratio to evaluate risk-adjusted returns, facilitating a nuanced comparison across different market capitalizations and investment styles. Our analysis indicates that funds in the Large category generally yield higher median returns compared to those in the Mid-Cap and Small categories. The research highlights the critical role of considering both risk and return in making informed mutual fund investment decisions. By providing a detailed overview of performance trends within this period, the study offers valuable insights into the dynamics of fund performance that could assist investors in strategic portfolio construction.

АННОТАЦИЯ

Данное исследование проводит изучение эффективности паевых фондов в период с 2010 по 2023 год по классификации Morningstar, включающей в себя категории: по стилю инвестирования – рост, стоимость и смешанный, по капитализации компаний для инвестирования – малые, средние и большие. В анализе используется коэффициент Шарпа для оценки доходности с поправкой на риск, что облегчает сравнение различных рыночных капитализаций и стилей инвестирования. Результаты показывают, что фонды, инвестирующие в компании большой капитализации, приносят более высокую среднюю доходность по сравнению с фондами, инвестирующими в компании средней и малой капитализации. Исследование подчеркивает ключевую роль учета как риска, так и доходности при принятии инвестиционных решений при инвестировании в паевые фонды. Исследование показывает тенденции эффективности доходности паевых фондов за период с 2010 по 2023 годы, которые могут помочь инвесторам в принятии решений при построении долгосрочного портфеля на основе паевых фондов.

Keywords: mutual funds, Morningstar style box, market capitalization, investment style, fund performance, Sharpe ratio, risk-adjusted returns.

Ключевые слова: паевые фонды, классификация Morningstar, рыночная капитализация, стиль инвестирования, доходность фонда, коэффициент Шарпа, риск и доходность.

INTRODUCTION

The landscape of mutual fund investing is both vast and complex, with myriad options available to both seasoned and novice investors. Understanding the nuances of fund performance across different market capitalizations and investment styles is crucial for constructing a portfolio that aligns with an investor's risk tolerance and return expectations. This study embarks on a comprehensive analysis of mutual fund performance from 2010 to 2023, utilizing the Morningstar Style Box classification to dissect the market into Large, Mid-Cap, and Small segments across Growth, Blend, and Value investment styles.

At the heart of our analysis is the Sharpe ratio, a metric devised by Nobel laureate William F. Sharpe, which measures the risk-adjusted return of an investment. The Sharpe ratio offers a means to compare the performance of funds on a level playing field, adjusting for the risk undertaken to achieve returns. This study aims to leverage the Sharpe ratio to uncover patterns of performance across the Morningstar Style Box classifications, providing insights into which segments offer the most favorable risk-adjusted returns over the examined period.

This introduction sets the stage for a detailed exploration into the performance of mutual funds, framed by the Morningstar Style Box classification and analyzed through the lens of the Sharpe ratio. Our goal is to offer a nuanced understanding of mutual fund performance, enabling investors to navigate the complex investment landscape with greater confidence and strategic acumen.

LITERATURE REVIEW

The exploration of mutual fund performance, particularly through the lenses of market capitalization, investment style, and risk-adjusted returns, stands as a cornerstone of financial research. The Morningstar Style Box, an innovative classification tool, provides a clear, visual representation of a mutual fund's investment approach by size and style. Key studies that have validated the utility of this framework include those by Blake, Morey (2000) [1] and Barber, Odean, and Zheng (2005) [2], who explored the impact of style and size on fund flows and investor decisions. Also, Daniel, Grinblatt, Titman, and Wermers (1997) [3] and Cremers, Petajisto (2009) [4] examined the correlation between mutual fund performance and stock selection skill.

The Sharpe ratio, a metric for assessing risk-adjusted returns, has been pivotal in shaping investment strategy evaluation. Beyond Sharpe's original proposal (1966) [5], subsequent research has sought to refine and expand upon this concept. For instance, Markowitz (1952) [6] and Treynor (1965) [7] laid the groundwork for modern portfolio theory and the capital asset pricing model, respectively, which are foundational to understanding the risk-reward trade-off. More recent work by Jegadeesh and Titman (1993) [8] on momentum strategies, and by Ang, Hodrick, Xing, and Zhang (2006) [9] on the volatility effect in stock returns, further explores the complexities of risk-adjusted performance measurement.

The integration of the Fama and French three-factor model (Fama and French, 1993) [10] and its extensions, such as the five-factor model (Fama and French, 2015) [11], into mutual fund performance analysis has been a significant advancement. These models provide a framework for understanding the dimensions of risk and return in mutual fund investments, emphasizing the role of size, value, and other factors in predicting returns.

The persistence of mutual fund performance is a contentious topic, with studies such as those by Carhart (1995, 1997) [12,13], who introduced a fourth momentum factor to the asset pricing model, and Bollen and Busse (2005) [14], who investigated the timing ability of mutual fund managers, offering diverse perspectives. Malkiel (1995) [15] found that, after accounting for expenses and transaction costs, the majority of actively managed funds underperformed passively managed index funds. These works highlight the challenges in achieving consistent outperformance and the importance of considering various factors, including management skill and market conditions, in fund evaluation.

Emerging research areas, such as the impact of environmental, social, and governance (ESG) factors on mutual fund performance (Renneboog, Ter Horst, and Zhang, 2008) [16], and the role of technological advancements in financial markets (Hendershott, Jones, and Menkveld, 2011) [17], underscore the evolving nature of investment management and its analysis.

This expanded literature review underscores the depth and breadth of research into mutual fund performance, market capitalization, investment style, and risk-adjusted returns. By building upon the seminal works of Sharpe, Fama and French, and others, while incorporating contemporary studies on emerging trends and methodologies, this paper aims to provide a comprehensive analysis of mutual fund dynamics across Morningstar Style Box classifications through the Sharpe ratio lens.

METHODOLOGY

The Morningstar Style Box is an industry-standard classification tool that provides a visual representation of a mutual fund's investment strategy. Introduced by Morningstar, Inc., it categorizes funds based on two dimensions: investment style (value, blend, or growth) and market capitalization (large, medium, or small). This 3x3 matrix results in nine distinct categories, enabling investors to understanding a fund's investment approach and risk characteristics.

The Sharpe Ratio, formulated by William F. Sharpe in 1966, is a metric used to assess the risk-adjusted performance of an investment, comparing its excess returns over the risk-free rate to its standard deviation of returns. In this study, the Sharpe Ratio serves as the cornerstone for evaluating and comparing the performance of mutual funds within each Morningstar Style Box, emphasizing the efficiency of investments in achieving higher risk-adjusted returns. For a long-term investment perspective, the study calculates the accumulated return over the entire study period, adjusted for volatility, to provide insights into the sustainability of returns relative to the risk taken. This can be represented by the formula for each mutual fund:

where  – certain annual return,  – number of years of each fund,  – volatility of the fund's annual returns  .

DATA OVERVIEW

Our study is underpinned by a comprehensive dataset that captures the performance of mutual funds across a pivotal 13-year period, from 2010 to 2023. This dataset, consisting of 1,710 mutual funds.

Within this dataset, the distribution of funds based on market capitalization revealed a diverse array of investment sizes: 878 funds were classified as large-cap, indicating a focus on companies with substantial market valuations known for their stability and resilience in the market. Meanwhile, 373 funds fell into the mid-cap category, targeting companies with moderate market valuations that balance growth potential and risk. The dataset also included 459 small-cap funds, which invest in companies with smaller market valuations, often seen as offering higher growth potential albeit with increased volatility.

Regarding investment style, the mutual funds were equally varied: 620 funds were identified as growth-oriented, focusing on companies expected to outperform the market in terms of revenue and earnings growth. Another 570 funds were categorized as blend, indicating a strategy that combines elements of both growth and value investing to provide a balanced approach to portfolio construction. Lastly, 520 funds were designated as value funds, targeting undervalued companies with the potential for price appreciation once the market recognizes their true worth. This classification into growth, blend, and value funds underscores the diverse strategies mutual fund managers employ to achieve risk-adjusted returns, forming the basis of our analysis into how different approaches to market capitalization and investment style impact fund performance.

The table presents a comprehensive annual overview of mutual fund performance, meticulously compiled to provide a snapshot of the investment landscape from 2010 to 2023. Within each cell, the table encapsulates three critical pieces of data: number of funds, average return and Sharpe ratio. For Large capitalization funds, the S&P 500 serves as the benchmark, while the Russell 2000 is used as the benchmark for both Mid-cap and Small funds.

Table 1.

Annual average returns and Sharpe Ratios by fund category

RESULTS

This section reveals our findings, with a particular emphasis on distribution graphs that illustrate the variability and distribution of returns and risk-adjusted performances across the various fund categories. Graphs were generated to depict these returns on a yearly basis, allowing for a visual comparison across the three primary investment styles (Growth, Blend, Value) and the three market capitalization categories (Large, Mid, Small). In analyzing fund return distributions, we emphasized key quantiles—2.5th percentile, median (50th percentile), and 97.5th percentile.

Figure 1. Distribution of average annual returns by fund category

Following the return analysis, we explored the Sharpe Ratios to assess risk-adjusted performance across the same style boxes and market capitalizations. This metric, crucial for understanding the efficiency of returns relative to the risk taken.

Figure 2. Distribution of Sharpe Ratios by fund category

Our examination of the mutual funds performance, delineated by the Morningstar Style Boxes from 2010 to 2023, reveals a nuanced interplay between average returns, risk as captured by volatility, and the risk-adjusted performance measured by Sharpe Ratios. The analysis, articulated through a series of distribution graphs for each style box category, uncovers a consistent pattern across the investment landscape: mutual fund categories that exhibit higher average returns also tend to have lower Sharpe Ratios. This inverse relationship highlights the elevated levels of risk associated with these higher-return categories, a consequence of their greater volatility.

Given the observed trade-off between returns and risk, as highlighted by the volatility's impact on Sharpe Ratios, a third chart was constructed to cater specifically to the perspective of a long-term investor. This chart represents an innovative approach to evaluating performance by calculating the accumulated return over the entire study period, then adjusting this figure by both the number of years and the observed volatility for these returns within each category. This methodology aims to normalize the returns for a more equitable comparison across time, providing a measure that encapsulates the essence of long-term investing by balancing the cumulative gains against the inherent volatility and the investment duration.

Figure 3. Distribution of annualized risk-adjusted return by fund category

The analysis of the density plots for mutual fund returns indicates that large-cap funds, on average, exhibit a higher median return relative to their mid-cap and small-cap counterparts. Within the large-cap category, the Large Blend funds are particularly noteworthy. Their density plot not only reveals a median return that surpasses other categories but also shows a peak that is skewed to the right. This rightward deviation suggests that the average return for Large Blend funds may be higher than the median return, highlighting their potential for yielding greater returns in comparison to the median figures of their large-cap peers. This characteristic of the Large Blend category stands out, suggesting that these funds could potentially offer a more attractive return profile for investors seeking to capitalize on the stability and performance of large-cap investments.

CONCLUSION

The extensive examination of mutual fund returns by Morningstar Style Box classifications over the period from 2010 to 2023 provides a clear picture of the performance landscape. Large-cap funds, particularly those in the Blend category, stand out with a median return that surpasses those of the mid-cap and small-cap classifications.

The Sharpe ratio proved invaluable in our analysis, enabling a nuanced comparison of funds by accounting for the risk undertaken to achieve returns. This study's findings underscore the utility of the Morningstar Style Box as a tool for investors seeking to navigate the complex landscape of mutual funds. By offering a clear, visual representation of fund characteristics, it aids in the selection of funds that align with individual investment goals and risk tolerance.

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