I NVESTING
THE JOURNAL OF
MUTUAL FUNDS SECTION
Morningstar’s Classification
of Large-Cap Mutual Funds
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JOHN A. HASLEM AND CARL A. SCHERAGA
JOHN A. HASLEM orningstar is an important
M
is a professor of finance source of mutual fund infor-
in the Robert H. Smith
School of Business at the
mation, data, and evaluation
for the investment commu-
University of Maryland
in College Park, MD. nity. We would like to be sure its approach to
such issues as a fund’s investment style pro-
CARL A. SCHERAGA vides reliable inputs to the decision process.
is an associate professor
Our objective is to determine whether
of business strategy and
technology management Morningstar’s classification of the invest-
in the School of Busi- ment styles of large-cap mutual funds as
ness at Fairfield Univer- large growth, large blend, and large value is
sity in Fairfield, CT. consistent with the groups and styles iden-
tified by cluster analysis. Style is Morn-
ingstar’s shorthand for the combination of
market capitalization (large, mid, and small)
and analytical methodology (growth, blend,
and value) that describes the focus of the
portfolio manager’s approach to security
selection.
The variables and data for the study
come from the January 1998 issue of Morn-
ingstar Investor. This publication reports the
Morningstar 500, which is described as the
“biggest and best” funds. Eighty-four funds
are categorized as large-cap. Of these, 32
are identified as large growth, 17 as large
blend, and 35 as large value.
These funds and their Morningstar
investment styles are listed in Exhibit 1,
which groups the funds as identified by clus-
ter analysis. One fund is omitted from the
study as a statistical outlier.
SPRING 2001
HYPOTHESIS AND
EMPIRICAL METHODOLOGY
We test the hypothesis that Morningstar’s
large-cap funds have been correctly classified
into three homogeneous style groups and,
further, that these groups are correctly iden-
tified as growth, blend, and value. To do so
poses an interesting methodological problem.
One approach would be to a priori define a
set of fund style groups, much as Morningstar
must do, and include the funds that meet the
stated criteria. Using pairwise t-tests of the
means of the variables that characterize the
group could enhance the reliability of this
approach (see Houpt [1983]), although it does
not appear this is done generally.
The major problem with an a priori
approach, even with use of t-tests, is the sub-
jective determination of the critical number of
statistically different means needed to con-
clude that a significant difference exists
between groups overall.
We use cluster analysis to avoid these
kinds of subjectivity problems. This method is
widely used for classification and is designed
explicitly to identify groups of entities sharing
certain common characteristics (see Hair et al.
[1987]). Its identification of homogeneous
groups thus provides a better understanding of
entity behavior.
In general terms, cluster analysis includes
a variety of multivariate methods that identify
similarity in variables and classifies them accord-
THE JOURNAL OF INVESTING 79
 EXHIBIT 1
Sample Mutual Funds by Cluster

Dreyfus Appreciation Large Growth

Morningstar
Enterprise Growth A Large Growth
CLUSTER #1 (30) STYLE
Fidelity Growth Company Large Growth
Babson Value Large Value
Founders Growth Large Growth
Davis NY Venture A Large Value
Harbor Capital Appreciation Large Growth
Dodge & Cox Stock Large Value
IDS Growth A Large Growth
Federated American Leaders A Large Value
IDS New Dimensions A Large Growth
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Fidelity Advanced Growth Opportunity T Large Value

Janus Twenty Large Growth
Fidelity Equity-Income Large Value
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Robertson Stephens Value + Growth A Large Growth

Goldman Sachs Growth & Income A Large Value
Stein Roe Young Investor Large Growth
Invesco Value Equity Large Value
Vanguard Tax-Managed Capital Appreciation Large Growth
Preferred Value Large Value
Vanguard U.S. Growth Large Growth
T. Rowe Price Equity-Income Large Value
White Oak Growth Stock Large Growth
Putnam Equity Income A Large Value
Domini Social Equity Large Blend
Salomon Brothers Investors O Large Value
Dreyfus Discovery Stock Large Blend
Scudder Value Large Value
Fidelity Blue Chip Growth Large Blend
USAA Income Stock Large Value
Fidelity Dividend Growth Large Blend
Vanguard Equity-Income Large Value
Fidelity Large Blend
Vanguard/Windsor Large Value
Fidelity Growth & Income Large Blend
Vanguard/Windsor II Large Value
Fidelity Magellan Large Blend
Warburg Pincus Growth & Income Comm. Large Value
Gateway Index Plus Large Blend
Papp America-Abroad Large Growth
Guardian Park Avenue A Large Blend
AIM Value A Large Blend
Invesco Industrial Income Large Blend
Fidelity Contrafund Large Blend
Janus Large Blend
Fundamental Investors Large Blend
MFS Massachusetts Invest. A Large Blend
Growth Fund of America Large Blend
MFS Research A Large Blend
Investment Company of America Large Blend
Northeast Investors Growth Large Blend
T. Rowe Price Dividend Growth Large Blend
T. Rowe Price Blue Chip Grth Large Blend
T. Rowe Price Growth Stock Large Blend
United Income A Large Blend
T. Rowe Price Spectrum Growth Large Blend
Vanguard Index 500 Large Blend
Scudder Growth & Income Large Blend
Torray Large Blend
Morningstar
Warburg Pincus Capital Appreciation Comm. Large Blend
CLUSTER #3 (12) STYLE
American Mutual Large Value
Morningstar
Clipper Large Value
CLUSTER #2 (41) STYLE
General Securities Large Value
American Century Income & Growth Large Value
Kemper-Dreman High Return Equity A Large Value
Fidelity Equity-Income II Large Value
Neuberger & Berman Guardian Large Value
Legg Mason Value Prime Large Value
Oakmark Large Value
Lexington Corporate Leaders Large Value
Oppenheimer Quest Opportunity A Large Value
Putnam Fund for Grth & Inc A Large Value
Sequoia Large Value
Selected American Large Value
Vontobel U.S. Value Large Value
Vanguard Growth & Income Large Value
Franklin Growth I Large Blend
Washington Mutual Investors Large Value
Oppenheimer Growth A Large Blend
American Century-20th Century Ultra Inv. Large Growth
Smith Breeden Equity Plus Large Blend
Bramwell Growth Large Growth
Columbia Growth Large Growth

80 MORNINGSTAR’S CLASSIFICATION OF LARGE-CAP MUTUAL FUNDS SPRING 2001

 ing to prespecified clustering criteria. Cluster analysis is a EXHIBIT 2
purely empirical and inductive method, which makes no Variable Definitions
prior assumptions about important differences in the data.
FASTCLUS is used in this study to identify the Cluster Variables Performance Variables
clusters (SAS/STAT User’s Guide [1989]). This is an iter- Cash Ratio (%) ROR–1 Year (%)
ative partitioning, non-hierarchical clustering algorithm P/E Ratio ROR–3 Year (%)
P/B Ratio ROR Category Rank
that produces disjoint clusters—those with both high
(1 = best, 100 = worst)
intercluster heterogeneity and high intracluster homo-
3-Year Earnings Morningstar Risk
geneity. In this case, three homogeneous style groups are Growth (%) (1.0 = U.S. Equity Average)
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identified in Morningstar’s set of large-cap funds (Exhibit Median Market Bear Market Rank
1). These style groups are identified on an ex post basis, Cap ($bil) (10.0 = worst)
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which of course precludes the need for subjective iden- Turnover (%) Worst 3-Month ROR (%)
tification of the groups. A set of clustering variables are Foreign (%) Morningstar Rating
used in the analysis, each representing an element of (star category, 5 = best)
portfolio style (Exhibit 2). Stocks (%) Beta
The optimal number of style groups is confirmed as Assets in Top 10 (%) R2 (%)
three on an ex post basis by application of the cubic clus- Number of Securities Management Fee (%)
tering criterion (Sarle [1983]) and the pseudo-F statistic Top 3 Sectors (%) Sales Charge (%)
Standard Deviation
(Calinski and Harabasz [1974]). Application of the cubic
Alpha (Jensen)
clustering criterion also produces evidence to support
Sharpe Index
the existence of elliptical non-hierarchical clusters, which
confirms that the appropriate clustering algorithm is used.
Further, application of Altman’s F-statistic finds statistically
significant differences (0.0001 level) in intercluster hetero- The clustering variables are used to define (label) the
geneity (Altman et al. [1981]). investment style of each identified cluster. The perfor-

EXHIBIT 3
Cluster Variable Means and Significant Pairwise Differences

Pairwise
Cluster Variable Cluster #1 Cluster #2 Cluster #3 Significance

Cash Ratio (%) 6.5 3.9 24.0 (1-3), (2-3)

P/E Ratio 23.0 27.9 23.7 (1-2), (2-3)

P/B Ratio 4.3 6.2 4.3 (1-2), (2-3)

3-Year Earnings Growth (%) 20.2 23.3 20.3 (1-2), (2-3)

Median Market Cap ($bil.) 14.9 26.1 19.0 (1-2)

Turnover (%) 48.4 59.8 42.9

Foreign (%) 10.2 4.9 2.2 (1-2), (1-3)

Stocks (%) 91.0 95.5 68.4 (1-3), (2-3)

Assets in Top 10 (%) 31.3 28.2 63.3 (1-3), (2-3)

Number of Securities 156.5 158.6 59.8

Top 3 Sectors (%) 58.0 57.2 76.2 (1-3), (2-3)

SPRING 2001 THE JOURNAL OF INVESTING 81

 mance variables are used to describe the performance
profile of each identified cluster. Means and standard
deviations of each of the two types of variables are com-
puted for each cluster.
Tukey’s Studentized range test finds pairwise
statistically significant differences (0.05 level) in both the
clustering variables and the performance variables (see
Tukey [1953]).
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includes 41 funds, 8 classified by Morningstar as value
funds, 16 as growth funds, and 17 as blend funds.
Thus, Morningstar’s mix of value, blend, and growth
funds reflects problems with its style classification scheme.
It is most successful in classifying growth funds because all
but one of the Morningstar growth funds lie in this clus-
ter. Morningstar has problems correctly classifying value
and blend funds.
Besides its growth style, Cluster 2 has the least diver-

RESULTS OF ANALYSIS BY CLUSTER sified domestic (only) asset allocation (it has the smallest
proportion of foreign securities), but the most diversified
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The results of the Tukey analysis are presented in
Exhibit 3 for the clustering variables and in Exhibit 4 for
the performance variables.
Cluster 2 is clearly shown by analysis of the clus-
tering variables to have a growth style. This cluster
security and sector holdings. The pairwise comparison of
each clustering variable reveals Cluster 2’s aggressive (most
risky) style, as measured by its significantly highest P/E
ratio, P/B ratio, and three-year earnings growth (%). Its
median market cap ($bil) is significantly higher than Clus-

EXHIBIT 4
Performance Means and Significant Pairwise Differences

Pairwise
Performance Variable Cluster #1 Cluster #2 Cluster #3 Significance

ROR–1 Year (%) 28.6 28.1 26.5

ROR–3 Year (%) 27.7 28.8 28.1

ROR Category Rank

(1 = best, 100 = worst) 39.7 31.5 41.5

Morningstar Risk
(1.0 = U.S. Equity Avg.) 0.7 0.9 0.7 (1-2), (2-3)

Bear Market Rank

(10 = worst) 4.5 6.8 3.8 (1-2), (2-3)

Worst 3-Month ROR (%) -6.0 -6.4 -6.1

Morningstar Rating
(star category, 5 = best) 4.2 4.0 4.1

Beta 0.8 1.0 0.8 (1-2), (2-3)

R2 (%) 81.2 83.5 77.8

Management Fee (%) 0.6 0.6 0.8

Sales Charge (%) 2.0 1.3 2.4

Standard Deviation 12.6 15.6 12.6 (1-2), (2-3)

Alpha (Jensen) 1.6 -1.2 2.5 (1-2), (2-3)

Sharpe Index 2.0 1.8 2.1 (1-2), (2-3)

82 MORNINGSTAR’S CLASSIFICATION OF LARGE-CAP MUTUAL FUNDS SPRING 2001

 ter 1 (only), which would be expected, because large-cap
growth stocks are generally larger than value stocks. The
comparison also reveals the cluster’s most concentrated
domestic asset allocation and least concentrated security
and sector holdings, as measured by its lowest cash ratio
(%) and foreign (%), largest stocks (%), and lowest assets
in top 10 (%) and top three sectors (%).
Cluster 2’s least diversified domestic asset allocation
probably represents its typical mix, rather than a current
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reflection of market-timing efforts. As a growth cluster,
the risk of its most concentrated domestic asset allocation
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is not likely offset or reduced by its least concentrated
security and sector holdings. This unlikely offset or reduc-
tion in risk is confirmed by analysis of the cluster’s risk
performance.
Cluster 2’s performance variables reveal its highest
risk profile and lowest risk-return performance. This risk
profile is consistent with growth funds. Pairwise com-
parison of each performance variable reflects its highest
risk profile and lowest risk-return performance, as mea-
sured by its significantly highest Morningstar risk, lowest
bear market rank, highest beta and standard deviation, and
smallest alpha and Sharpe scores. In fact, its alpha has the
only negative score in all clusters.
Cluster 3 is shown by analysis of the cluster variables
to have a value style, but value accompanied by the most
diversified asset allocation (which effectively broadens
Morningstar’s concept of value) to one identified here as
value(1). This cluster includes 12 funds, 9 classified by
Morningstar as value funds and 3 as blend funds. Thus,
Morningstar’s mix of value and blend funds in this clus-
ter again reflects problems with its style classification
scheme.
This value cluster also has the most diversified asset
allocation, but the least diversified security and sector
holdings. Pairwise comparison reveals Cluster 3’s most
conservative (least risky) style, as measured by its lowest
P/E ratio, P/B ratio, and three-year earnings growth (%).
It also reveals the cluster’s least concentrated asset alloca-
tion and most concentrated security and sector holdings,
as measured by its significantly highest cash ratio (%),
lowest stocks (%) and foreign (%), and highest assets in top
10 (%) and top three sectors (%).
Cluster 3’s most diversified asset allocation probably
reflects its typical mix, rather than efforts at market tim-
ing. This most diversified asset allocation likely offsets or
reduces the risk in Cluster 3’s least diversified security and
sector holdings; the latter suggests more focus on selec-
tivity than diversification. The likely offset in risk of the
SPRING 2001
concentrated security/sector holdings is confirmed by
analysis of the cluster’s risk performance.
Cluster 3’s performance variables reveal its lowest risk
profile and highest risk-return performance. This low
risk profile is consistent with value funds and also confirms
that the cluster’s most diversified asset allocation likely off-
sets or reduces the risk of its concentrated security/sec-
tor holdings. Pairwise comparison reveals Cluster 3’s
lowest risk and highest risk-return performance, as mea-
sured by the significantly lowest Morningstar risk, high-
est bear market rank, lowest beta and standard deviation,
and largest alpha and Sharpe scores.
Cluster 1 is shown by analysis of the cluster variables
to have a value style identified here as value(2), which is
accompanied by the most diversified security/sector hold-
ings. This cluster includes 30 funds, 18 classified by Morn-
ingstar as value funds, 1 as a growth fund, and 11 as blend
funds. Again, Morningstar’s mix of value and blend funds
plus one growth fund indicates problems with its style clas-
sification scheme.
Cluster 1 also has the least diversified asset allocation
and the most diversified security and sector holdings.
Pairwise comparison of each clustering variable reveals
Cluster 1’s most conservative (least risky) style, as measured
by its lowest P/E ratio, P/B ratio, and three-year earnings
growth (%). It also reflects the cluster’s most concentrated
asset allocation and least concentrated security and sector
holdings, as measured by the significantly lowest cash
ratio (%), highest stocks (%) and foreign (%), and lowest
assets in top 10 (%) and top three sectors (%).
Cluster 1’s least diversified asset allocation probably
reflects its typical mix, rather than current market-timing
efforts. The reason is that the risk impact of this least
diversified asset allocation is likely offset or reduced by its
most diversified security and sector holdings; the latter sug-
gests more focus on diversification than selectivity. The
likely offset in risk of the concentrated asset allocation is
confirmed by analysis of the cluster’s risk performance.
Cluster 1’s performance variables reveal its lowest
risk profile and highest risk-return performance. This low
risk profile is consistent with value funds and confirms
that the cluster’s most diversified security and sector
holdings likely offset the risk of its least diversified asset
allocation. Pairwise comparison reflects its lowest risk and
highest risk-return performance, as measured by its sig-
nificantly lowest Morningstar risk, best bear market rank,
lowest beta and standard deviation, and highest alpha
and Sharpe scores. The latter performance scores are the
highest in all clusters.
THE JOURNAL OF INVESTING 83
 EXHIBIT 5 Overall, the more conservative risk and, especially,
Mix of Morningstar Styles by Cluster better risk-adjusted performance profiles of the two het-
erogeneous value clusters are the major factors differen-
Morningstar Style tiating their performance from the growth cluster (see
Cluster Large Growth Large Value Large Blend Haslem [1988]). Morningstar’s failure to recognize the dif-
1 = Value (2) 1 18 11 ferent dimensions of diversification among value funds, as
well as the different risk and risk-adjusted performance
2 = Growth 16 8 17
profiles of value and growth funds, may explain its prob-
3 = Value (1) 0 9 3
lems in classification of fund style.
n = 83 17 35 31
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REFERENCES
The Journal of Investing 2001.10.1:79-89. Downloaded from www.iijournals.com by NEW YORK UNIVERSITY on 09/01/16.

Numbers in bold misclassified by Morningstar.

Altman, E.I., R.B. Avery, R.A. Eisenbeis, and J.F. Sinkey, Jr.
OVERALL RESULTS OF ANALYSIS Applications of Classification Techniques in Business, Banking, and
Finance. Greenwich, CT: JAI Press, 1981.
Cluster analysis of the Morningstar 500 style classi-
fications (growth, blend, and value) of large-cap mutual Calinski, T., and J. Harabasz. “A Dendrite Method for Clus-
ter Analysis.” Communications in Statistics, 3 (1974), pp. 1-27.
funds identifies three homogeneous style groups: growth,
and two versions of value. The mix of Morningstar styles Hair, J.F., Jr., R.E. Anderson, and R.L. Tatham. Multivariate
in each identified cluster reflects problems in correctly clas- Data Analysis with Readings, 2nd ed. New York: Macmillan
sifying fund style, most particularly for value and especially Publishing Co., 1987.
blend funds. Exhibit 5 indicates that Morningstar mis-
classifies only one of its 17 growth funds—clustered as Haslem, J.A. The Investor’s Guide to Mutual Funds. New York:
value(2). Assuming the least misclassification of the 35 value Prentice-Hall, 1988.
funds, 8 are clustered as growth and 9 as value(1). And,
finally, all 31 of Morningstar blend funds are misclassified: Houpt, J.V. “Foreign Ownership of U.S. Banks: Trends and
17 clustered as growth, 3 as value(1), and 11 as value(2). Effects.” Journal of Bank Research, 14 (Summer 1983), pp. 144-
The two value clusters (Clusters 1 and 3) are basi- 156.
cally statistically equivalent, except for their significantly
Morningstar Investor, January 1998.
different approaches to asset allocation and security/sec-
tor diversification. Cluster 1 has the most diversified secu- Sarle, W.S. “SAS Technical Report A-108: The Cubic Clus-
rity/sector holdings, and Cluster 3 has the most diversified tering Criterion.” SAS Institute, 1983.
asset allocation. Both value clusters and the growth clus-
ter have statistically equivalent turnover (%) and number SAS/STAT User’s Guide, ver. 6, 4th ed., vol. 1. Cary, NC: SAS
of securities, although Cluster 2 has the largest number. Institute, 1989.
The most interesting aspect of the analysis is that all
clusters have statistically equivalent ROR-1 Year (%), Tukey, J.W. “The Problem of Multiple Comparisons.” Work-
ROR-3 Year (%), and ROR category rank. The same is ing paper, 1953.
true for worst three months ROR (%), Morningstar rat-
ing, 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.

84 MORNINGSTAR’S CLASSIFICATION OF LARGE-CAP MUTUAL FUNDS SPRING 2001

 “Morningstar’s Classification of
Large-Cap Mutual Funds”: Comment
MICHELE GAMBERA, JOHN REKENTHALER, AND XIAOHUA XIA
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n the article, “Morningstar’s Classification of Large-
I Cap Mutual Funds,” Haslem and Scheraga (hence-
The Journal of Investing 2001.10.1:79-89. Downloaded from www.iijournals.com by NEW YORK UNIVERSITY on 09/01/16.
forth HS) question the reliability of Morningstar’s
style classification of large-cap mutual funds. As is
well known, Morningstar classifies a mutual fund accord-
ing to the price-earnings and price-book ratios of the
stocks the fund owns. This is possible because Morningstar
has access to updated information about a fund’s holdings.
Funds are classified as “value” if their holdings are mainly
of value stocks, “growth” if most holdings are growth
stocks, and blend in intermediate cases.1
HS present the outcomes of a cluster analysis pro-
cedure, carried out with one set of variables that only
partly coincide with the variables that Morningstar uses.
The three clusters obtained are not rejected by diagnos-
tic tests. HS claim that when Morningstar’s classification
differs from the outcome of the clustering procedure,
this reveals “problems in [Morningstar’s] classification of
fund style” [2001].
VALUE AND GROWTH
“Value” does not describe an observable character-
istic of a financial asset.2 It is an arbitrary label. Labels such
as growth, value, and blend are useful to investors only
insofar as they describe future behavior. If they are not pre-
dictive, they are not useful, because they do not add any-
thing to the investor’s knowledge.
HS show that Morningstar’s style definitions do not
perfectly match the classification obtained using cluster
analysis. This is not surprising. Investment style is by def-
inition a classification system; it is thus not likely to gen-
erate the same output as cluster analysis. At the same
time, cluster analysis is a statistical procedure, and it may
involve some error (because it tries to deduce some unob-
served feature of the data).
HS fail to answer questions such as: How do we, the
audience, interpret the clusters? What useful insights do they
provide? Do such clusters rely on an alternative style defi-
nition that can improve upon Morningstar’s approach? Do
SPRING 2001
the clusters prove more predictive than Morningstar’s clus-
ters? It should not be too hard to assess the out-of-sample
performances of both approaches and address such questions.
Differences between the Morningstar approach and
the cluster analysis approach do not necessarily indicate
that Morningstar is inaccurate. The authors claim that a
value-growth categorization system has to “recognize
the different dimensions of diversification among value
funds” [2001]. This may be a useful way to redefine the
traditional concepts of value and growth, but the authors
do not explain why.
Would this approach have better predictive power,
and should we then have six clusters (three for diversi-
fied large-cap value/blend/growth, and three more for
concentrated value/blend/growth funds)? HS do not
address this.
STATISTICAL ISSUES
We have some statistical concerns about the results
in the HS article. One particular question is why HS
choose the cluster variables listed in Exhibit 2. Clearly, this
set of variables is not the same as that used by Morningstar,
as well as by most researchers and practitioners. It is not
explained why HS do not start with the same set of vari-
ables. They could later test whether the results are robust
to augmented sets of cluster variables, and test a number
of such sets—not just one.
By including such variables as turnover ratio and for-
eign stock composition from the beginning, HS compli-
cate their attempt to make a fair comparison between
Morningstar’s approach and their cluster analysis approach.
This becomes clear when HS spend time explaining
which cluster is which. Naturally, such groups must be
analyzed to understand which one represents value and
which one growth. Yet the introduction of a number of
different cluster variables implies that clusters may be
affected by exposure to certain sectors or to international
stocks, rather than only by whether a fund owns value or
growth stocks.
THE JOURNAL OF INVESTING 85
 Foreign exposure and diversification have little to do
with the traditional definitions of growth or value. A sta-
tistical procedure that includes them is bound to produce
clusters different from value versus growth. If the clusters
are based on such other factors, they are not comparable
to the Morningstar definitions, and any comparison with
the Morningstar clusters is inappropriate.
HS use data that are inconsistent with those used by
Morningstar—which may explain part of the differences.
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on a daily basis. The article is unclear from a financial point
of view, though, because we do not learn whether the
authors wish to redefine value versus growth, and because
claims are made and not proven. From a statistical point
of view, the article is incomplete as well, because the
analysis uses different variables from the ones considered
in the traditional definition of value, and no attention is
paid to the robustness and stability of the results with
respect to variable choice and clustering algorithm.

This is an important point, since the lack of a model The authors make a number of claims that they do
implies that any choice of cluster variables and any char- not prove. Such an important topic deserves further and
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acterization of the obtained clusters is arbitrary, and if one more thorough investigation.
model differs from another, it needs not be incorrect.
There are several cluster analysis algorithms in the ENDNOTES
SAS software package used by the authors, but HS appear
to use only one. HS say that the clustering they perform Rekenthaler is president of online advice, and Gambera
is not rejected by the tests. This is very good, but other and Xia are senior quantitative analysts, all with Morningstar, Inc.
1
clustering algorithms may yield a different three clusters, Further details can be obtained on-line at http://quick-
which in turn may not be rejected by the diagnostic tests. take.morningstar.com/DataDefs/FundPortfolio.html or from
the authors.
HS present the results of cluster analysis as definitive, but 2
The label “technology stock” is not sample-dependent,
fail to provide evidence that this, out of many possible
because either a company is active in the technology sector, or
cluster procedures and variable choices, is the only exact it is not. The definition of value is sample-dependent, however,
one—but they clearly assume this to be the case, because because it refers to the stocks with relatively low price-earn-
they characterize any different result as unquestionably ings compared to the other stocks in the group. Therefore, the
inaccurate. Testing the robustness of the method to dif- same company, in another country, could end up being labeled
ferent sets of cluster variables would be recommended. differently. Labels such as “value” and “growth” do not describe
HS calculate the clusters only for one sampling absolute characteristics of a financial asset, unlike labels such as
period. Why do they not try them also with Morningstar “technology” or “East Asian.”
FundInvestor 1997, or test them out of sample with Fund-
Investor 1999? This is important because it may be that
Morningstar results may coincide with the clusters of other
sampling periods; they may differ only for the 1998 case.
The variables are listed in Exhibit 2 but not
explained (“Top 3 Sectors %” is clear only if the reader
is familiar with Morningstar data). Exhibits 3 and 4 are
interesting, but it would be better if they reported stan-
dard deviations in addition to the means, since HS say they
calculate both. It is difficult to see why the tables in HS
do not compare the statistics from each of their clusters
to those of the Morningstar groups. In this way, it would
be possible to evaluate HS’s claim that Morningstar fails
to recognize diversification.

CONCLUSION

As a whole, the HS study is interesting, because it

hints at statistically sound ways that Morningstar’s products
can be verified and improved. Moreover, it stimulates a dis-
cussion of a topic that is of great importance to all investors

86 MORNINGSTAR’S CLASSIFICATION OF LARGE-CAP MUTUAL FUNDS: COMMENT SPRING 2001

 “Morningstar’s Classification of
Large-Cap Mutual Funds”: Reply
JOHN A. HASLEM AND CARL A. SCHERAGA
It is illegal to make unauthorized copies of this article, forward to an unauthorized user or to post electronically without Publisher permission.
n the spirit of Blume [1998] and Sharpe [1997], the
I
Haslem and Scheraga article analyzes Morningstar’s
The Journal of Investing 2001.10.1:79-89. Downloaded from www.iijournals.com by NEW YORK UNIVERSITY on 09/01/16.
large-cap value/growth investment style to deter-
mine if it can be improved. If so, this should work
to the benefit of Morningstar and its many subscribers.
Morningstar data and research findings are very helpful,
especially to individual investors who lack resources avail-
able to institutional investors. For example, Morningstar’s
cooperation was essential to a mutual funds text forth-
coming from Blackwell.
As noted by Gambera, Rekenthaler, and Xia [2001],
any style classification system is arbitrary, but use of these
ratio variables has been widely validated as, for example,
in Dreman [1998]. Our analysis includes these variables
and others that a priori and/or empirically vary by invest-
ment style. This more comprehensive variable set provides
investors with an expanded field of vision for identifying
value and growth investment style. The variables were pro-
vided by Morningstar, primarily Morningstar [1998].
Morningstar’s investment style constructs are also
helpful in identifying whether a fund’s growth or value
investment style appears to be changing. The Morn-
ingstar category identifies a domestic equity fund’s invest-
ment style over the last three years, and the investment
style identifies it over the last year. Evidence of different
investment styles between these constructs posts a “red
flag” that the fund’s longer-term investment style, and
therefore risk and performance, may be changing.
The variable clusters and their contents were iden-
tified using the clustering techniques statistically best suited
for the analysis. No other clustering techniques were used
to avoid what could have been a search for particular out-
comes, such as number of clusters identified. The clus-
tering method used seeks to maximize benefits of both
hierarchical and non-hierarchical techniques. First, a hier-
archical technique was used to establish the number of clus-
ters, profile the cluster centers, and identify and eliminate
any obvious outliers. Second, a non-hierarchical tech-
nique was used to cluster the observations using the pre-
viously determined cluster centers as initial seed points.
SPRING 2001
The clustering references are cited in the article.
The identified clusters are very easy to interpret as
versions of value and growth investment styles. The clus-
ters also provide more complete profiles of fund variables
and the significance of their differences between clusters
(article Exhibits 3 and 4). As noted above, these profiles
provide a broader and more precise sense of the greater
nature of value and growth investment styles.
To provide this broader definition of investment
style, the first step in Exhibit 3 identified the P/E and P/B
ratios for each cluster. Each ratio is statistically equal in
Clusters 1 and 3, but each is significantly smaller than in
Cluster 2. Voila! Clusters 1 and 3 are value portfolios and
Cluster 2 is a growth portfolio.
The second step identified other significantly dif-
ferent variables between the growth cluster and both value
clusters. Only the 3-Year Earnings Growth Rate is sig-
nificantly different between Cluster 2 and both Clusters
1 and 3. As expected, the earnings growth rate is largest
in the growth cluster.
The third step identified other significantly differ-
ent variables between the growth cluster and each value
cluster. In total, the significantly different variables include
the Cash Ratio (%), Market Cap (median size), Foreign
Stock (%), Stock (%), Top Ten Stock Holdings (%) , and
Top Three Industry Sectors (%). The latter two variables
reflect security concentration and industry sector con-
centration. The variables that are significantly different
between Cluster 2 and each of Clusters 1 and 3 are found
in Exhibit 3. Portfolio concentration aspects of these
relationships are discussed below.
The fourth step in Exhibit 3 identified significantly
different variables between the two value clusters. This step
provides more complete profiles of differences between
Clusters 1 and 3. As noted above, the P/E and P/B ratios
in each cluster are statistically equal. However, significant
differences are found in the Cash Ratio, Foreign Stock
(%), Stock (%) , and in both security and industry sector
concentration. Cluster 3 is more conservative than Clus-
ter 1 with respect to its larger relative holdings of cash and
THE JOURNAL OF INVESTING 87
 smaller relative holdings of stock to total assets. But, Clus-
ter 3 is less conservative than Cluster 1 with respect to its
larger concentration of both security holdings and indus-
try sector holdings.
Next, the first step in Exhibit 4 identified the sig-
nificantly different performance variables between the
two value clusters. There are no significantly different per-
formance variables between Clusters 1 and 3. None!
Thus, in spite of identified differences in portfolio allo-
It is illegal to make unauthorized copies of this article, forward to an unauthorized user or to post electronically without Publisher permission.
cations, the performance profiles of the value clusters are
statistically equal. This finding alone warrants additional
The Journal of Investing 2001.10.1:79-89. Downloaded from www.iijournals.com by NEW YORK UNIVERSITY on 09/01/16.
study, as well as testing later data to see if these results are
consistent over time.
The second step identified the significantly differ-
ent performance variables between the growth cluster
and each value cluster. Interestingly, the same variables are
significantly different between Cluster 2 and each of value
Clusters 1 and 3. Complete consistency! Significant dif-
ferences are found in Morningstar Risk, Bear Market
Rank, beta, standard deviation, Jensen Alpha Index, and
Sharpe Index. The growth cluster is significantly more
aggressive in each risk measure and also has significantly
lower composite risk/return performance as measured by
the Jensen and Sharpe measures.
And, the third step in Exhibit 4 identified the per-
formance variables that are equal in each cluster. The
variables that are statistically equal for Clusters 1, 2, and
3 include ROR–l Year (%), ROR–3 Years (%), ROR Cat-
egory Rank, Worst 3-Month ROR, Morningstar Rating
(!), R2, Management Fees (%), and Sales Charge (%).
Interestingly, the return variables and non-market risk are
statistically equal in each cluster.
Thus, the identified performance differences between
the growth cluster and each value cluster are only in the risk
and risk-adjusted performance measures, but not the return
measures. It is interesting that the Jensen and Sharpe com-
posite risk/return variables are significantly different between
growth Cluster 2 and each of the value Clusters 1 and 3,
but the Morningstar Rating is not. The Morningstar Rat-
ing is statistically equal for the clusters. All three!
This equality in the Morningstar rating is interest-
ing, but more so because Morningstar’s Regneir [1997]
claimed that also providing the Sharpe measure would be
redundant. The two measures “…do pretty much the
same thing.” This equality could perhaps result if the
Morningstar Rating drives selection of the Morningstar
500 funds. But, if the two measures are redundant why
does the same equality not apply to the Sharpe measure?
The Sharpe measure is significantly different between
88 MORNINGSTAR’S CLASSIFICATION OF LARGE-CAP MUTUAL FUNDS: REPLY
the growth cluster and each value cluster. A more repre-
sentative sample of the large-cap funds may provide dif-
ferent results.
Moreover, R2 is statistically equal for each cluster.
It is interesting that non-market risk (1 – R2) does not
vary between clusters. This may reflect both similarities
and differences in portfolio concentration for the clusters
(Exhibit 3). The growth Cluster 2 and value Cluster 1 are
statistically equal with respect to Cash Ratio (%), Stock
(%), Top Ten Stock Holdings (%), and Top 3 Industry Sec-
tors (%). That is, value Cluster 1 and the growth cluster
have equal portfolio concentration along these dimensions.
And, both Clusters 1 and 2 have significantly smaller
portfolio concentration than value Cluster 3 for these same
variables. Clusters 1 and 2 have smaller Cash Ratios (%),
Top Ten Stock Holdings (%), and Top 3 Industry Sectors
(%), but larger Stock (%). Thus, value Cluster 1 and
growth Cluster 2 are more alike than different with respect
to these measures of portfolio concentration.
The statistical equality of R2 warrants additional
study to explain the cause, as well as testing later data to
see if these results persist. The large-cap fund sample and
the variable that drives its selection may be factors. The
Median Market Caps of value Cluster 1 and growth Clus-
ter 2 are significantly different, with the growth cluster
holding the largest stocks. But, this is the only significant
difference in cluster size. More representative samples of
large-cap funds and of all funds may provide different
results.
The upshot of the cluster analysis is identification of
three value/growth investment style clusters for a selected
sample of large-cap stocks, along with comprehensive
profiles of cluster style and performance variables. The
cluster profiles reflect both statistically different and equal
variables. The clusters support use of P/E and P/B vari-
ables in distinguishing investment styles, but here the
style construct consists of two versions, one of value
investing and one of growth, and includes more complete
sets of style and performance variables.
The results support additional research with later data
and a more representative fund sample. Comprehensive
variable profiles provide opportunities to identify more
precisely defined investment styles and to test perfor-
mance implications. Morningstar is concerned with the
power of variables to predict performance. But, first, the
expanded variable set and its cluster relationships need to
be tested for persistence. This test will more likely be suc-
cessful if applied to a more representative sample of large-
cap funds with very low P/E and P/B ratios within the
SPRING 2001
 expanded variable set, similar to the approach taken by
Dreman [1998].
To conclude, there are several steps that should be
taken using later large-cap fund data from the Morn-
ingstar 500. Next, the same steps should be followed to val-
idate or improve findings using, first, more representative
large-cap fund samples and, second, representative samples
of all funds. First, determine if the finding of two value
clusters and one growth cluster persists. Second, determine
It is illegal to make unauthorized copies of this article, forward to an unauthorized user or to post electronically without Publisher permission.

if the findings concerning cluster variables persist. Third,

determine if the findings concerning performance variables
The Journal of Investing 2001.10.1:79-89. Downloaded from www.iijournals.com by NEW YORK UNIVERSITY on 09/01/16.

persist. And, fourth, determine how effective “stable”

clusters are in identifying funds that will outperform. As
part of this total process, it will be interesting to see how
Morningstar Ratings and R2s fare and why.

REFERENCES

Blume, Marshall. “An Anatomy of Morningstar Ratings.”

Financial Analysts Journal, March/April 1998, pp. 19-27.

Dreman, David. “Contrarian Investment Strategies: The Next

Generation.” New York: Simon & Schuster, 1998.

Gambera, Michelle, John Rekenthaler, and Xiaohua Xia.

“Morningstar’s Classification of Large-Cap Mutual Funds—
Comment.” The Journal of Investing, Spring 2001.

Haslem, John A. Mutual Funds: Risk and Performance Analysis for

Decision Making. Oxford: Blackwell Publishers, forthcoming.

“Morningstar 500.” Morningstar Investor, January 1998.

Regnier, Pat. “What Is…Sharpe Ratio.” Morningstar Investor,

August 1997, p. 13.

Sharpe, William F. “Morningstar’s Risk-Adjusted Ratings.”

Financial Analysts Journal, July/August 1998, pp. 21-33.

SPRING 2001 THE JOURNAL OF INVESTING 89