New Investment Categories: What It Means for Your Plan By: Gabriel PotterMBA, AIFA® 2019.08.21

Are my investments good?

Here’s a seemingly straightforward question:  how good, or bad, are your investments?  For the layperson, the gut-level response depends on how the overall markets are doing.  If you own a stock-fund during a stock market rally, you’d notice your balances growing each month and suppose, “My investments are good.”  If you own the same stock fund during a crash, you might think, “My investments are bad.”

That’s the instinctual way to look at it but most investors - even novices and laypeople - have internalized the oft-repeated message from professionals:  don’t get into, or out of, the market based on unpredictable rallies and crashes.  Timing the market is a fool’s game, with many more losers than winners.  Even during a stock market crash, a reasonably well-informed novice knows not to panic, liquidate their investments, and realize the loss. 

Determining if an investment as “good” or “bad” is, presumably, actionable information.  In other words, any investor might like to avoid “bad” investments and stick with “good” ones, regardless of how the market is doing.  Therefore, a more thoughtful examination of “how good are your investments?” suggests the quality of the investment does not depend on how the market is performing at the time.

How do professionals determine if an investment is good or bad?  The method for making that assessment is typically found through comparison.  Consider your investment versus its peers and then make the judgement.  Does your investment generate more return than peers, and, most critically, why does this happen?  If the market is experiencing a rally, does this fund tend to lag behind?  If the fund underperforms during stock market rallies, does it make up for that deficiency by retaining more value during inevitable stock market downturns?   Are its risk metrics better the competitors’ products?  A good investment should have some advantage – qualitative or quantitative – relative to its peers.  Thus, understanding the attributes of your investment and comparing it to peers is vital to determining its quality and whether it is worth keeping.  Once you have done the comparison, you then have actionable information. 

Comparison versus peers

If investments are determined to be good or bad relative to their peers, then we next have to ask:  how do we determine the peers for the investment?  This question is only occasionally difficult, particularly for atypical alternative investments e.g. absolute-return hedge funds.  For common investments, it is perfectly reasonable to rely on industry-standard peer categories.  For instance, if you are evaluating a mutual fund that targets large domestic companies which are anticipated to grow more quickly, then the appropriate peers for the investment are found in the US Large Growth category.  Global financial service firms - like Thompson Reuters Lipper, Morningstar, and others - create and manage these categories.

Similarly, benchmarking an investment’s performance versus a corresponding industry-standard index is equally appropriate.  Continuing our example, a mutual fund in the US Large Growth category may be fairly benchmarked against the Russell 1000 Growth Index.  Again, global financial service firms and industry professionals determine the standard index benchmark for investment categories.

The common investment categories don’t change…

We have asserted that an investment’s perceived quality depends on the group it is compared against.  For newer, experimental categories with esoteric investments, changes in the underlying categories are frequent.  Case in point:  in 2011, Morningstar created 10 alternative asset classes and they’ve been tweaking their classification system (adding and combining categories, changing underlying index benchmarks) ever since.  On the plus side, for common investment categories, the categorization scheme has been very stable.  Typically, a few funds get added and subtracted to any given category each quarter as various companies go out-of-business or change direction.  The common investment categories – which represent the bulk of assets in investment lineups – don’t change much and the corresponding index benchmarks almost never change.

…until they do

So, it’s a pretty big shock when the foundational categories do change. It just happened in the second quarter of 2019 to one of the biggest categories. 

In the broad terms, the three major classifications of investments for a typical US investor are bonds, stocks, and cash.  The commensurate Morningstar classifications would be the US intermediate term bond, US large blend equity, and US taxable money categories.  In May 2019, the intermediate term bond category, representing $1.3 trillion in assets, was eliminated and replaced with two new categories:  intermediate core bond and intermediate core-plus bond.

There were already around 20 US taxable fixed income categories which Morningstar classified.  The spectrum of US fixed income categories were acceptably specific, delineating funds by interest rate risk (i.e. duration), credit risk, and even included esoteric approaches (i.e. nontraditional bonds).  The old schema drew a line between core bond holdings and the multisector bond category which had more diversified investments.  The new schema retains and purifies the traditional core bond holding category but it adds a new halfway grouping, the core-plus category, in-between core bonds and multisector bonds.  More specifically, Morningstar describes the core-plus category: “Intermediate core-plus bond portfolios invest primarily in investment-grade U.S. fixed-income issues, including government, corporate, and securitized debt, but generally have greater flexibility than core offerings to hold noncore sectors such as corporate high yield, bank loan, emerging-markets debt, and non-U.S. currency exposures.”  This almost precisely describes the multisector bond category as well; the essential difference is only between the weights of different bond types.

Other new categories

In this newsletter, we’ve focused on the change to the core-bond category.  For the sake of thoroughness, it’s worth noting that Morningstar simultaneously split apart its global bond category in May 2019 into two new distinct categories:  those which global bonds which are hedged to the US dollar, and global bond funds which remain unhedged.  Our forthcoming advice for managing the change to core-bonds equally applies to global bond investors. 

What these changes mean to you

At long last, we arrive at the point of this newsletter.  It is this:  pay attention to your bond investments.  Ask questions.  At a bare minimum, your core bond investment just changed its peer group since the original peer group was split into two halves.  Furthermore, if your fund was placed into the core-plus category, your index benchmark has also changed.  While the original intermediate term bond category and the new intermediate core bond category both maintain the Barclays US Aggregate Bond index, the core-plus category is now being measured against the Barclays US Universal Bond index, a more diverse benchmark used for multisector bond funds. 

Imagine you are part of the investment committee monitoring your company’s 401(k) plan.  Your company’s 401(k) plan includes the Denver Total Return Bond Fund as the centerpiece of the lineup as it’s the biggest part of the plan.  In the long term, the Denver fund was outperforming traditional core bond peers because it had a modest (10%-15%) allocation to investment grade credit.  However, that credit allocation has pushed the Denver fund into the new core-plus category under the new schema.  Now, the Denver fund has a smaller proportion of investment grade credit relative to peers, because the comparable set of peers has changed to the slightly higher-octane managers within the core-plus category.

The Denver Bond Fund might have been beating the original Barclays Aggregate Index, but it falls behind the new Universal Bond Index measuring stick.  The Denver fund was slightly ahead of its original, combined intermediate term bond category fund, but now it’s being measured against a set of peers who have all opted for greater credit risk, so it’s falling behind.  The Denver fund originally looked like it was outperforming peers and the index, but now it is underperforming peers and its new index due to the re-categorization. 

Due to the performance standards in your Investment Policy Statement, your investment committee may require greater scrutiny of the Denver fund, even though nothing has intrinsically changed in the fund’s operations, long term metrics, or expected outcome.  Moreover, some Investment Policy Statements specify the acceptable investment categories available to a board or committee.  Imagine if your IPS specifically requires your company to maintain a “core-bond” holding and your core-bond investment just changed into core-plus.  It may be required to modify the IPS or change your plan’s investment lineup.

Practically speaking, in the long term, there’s not a tremendous amount of difference between the historical performance of the two indices or the two new categories.  For instance, the 10 year return of the US Aggregate Bond index is 3.75% whereas the 10 year return of the Barclays US Universal Bond index is 4.21%.  The new categories add a level of granularity, but they aren’t quantum leaps of difference.  Still, the new bond categories will create changes to investor reports.  Investment committees should equip themselves with an additional level of understanding and prepare themselves for additional due-diligence duties related to this change. 





Gabriel Potter

Gabriel is a Senior Investment Research Associate at Westminster Consulting, where he is responsible for designing strategic asset allocations and conducts proprietary market research.

An avid writer, Gabriel manages the firm’s blog and has been published in the Journal of Compensation and Benefits,...

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