Morningstar Advisor - Summer 2008 - (Page 23)

Minor Differences Flexibility Doesn’t Matter The style flexibility of a fund manager has little bearing on whether his or her fund will outperform funds with different flexibilities. Style-hoppers do not consistently out- or underperform style purists by significant margins. Trailing Three-Year Returns, Relative to Category (3/31/08), in Basis Points Category Flexibility of Style High Moderate Low This visual pattern tells the story quite clearly —no story. For the trailing three- and five-year periods, high-flexibility funds were marginally better than moderate, and moderate slightly superior to low flexibility. The margin of victory, however, was tiny indeed. For the three-year period, high flexibility had two greens, no reds, and seven uncoloreds among the nine style-box categories, while low flexibility had one green, two reds, and six uncoloreds. The five-year results were similarly tight. Over the 10-year period, however, the highflexibility funds reversed course and showed marginally worse results. Moreover, over the entire sample size of the three time periods, the moderate-flexibility group had the greatest number of green results. If flexibility is a true factor (for good or ill), then it is quite odd to see funds with a middle-of-the-road approach to that factor finish the best. Therefore, it seems safe to say that in aggregate the degree of a portfolio manager’s flexibility is not relevant to an advisor when determining the merits of his or her fund. This precept also holds true for the funds’ risks. We could publish a similar series of charts for the flexibility groupings’ average annualized standard deviations, but that would require using a great deal of space to tell the same story: The level of flexibility really does not matter. Some time periods, for some categories, the high-flexibility funds were the most volatile, other time periods the moderates and lows were. In almost all cases, the margins were very small, well under 1 percentage point of standard deviation. Neither was there a visible effect on lists of the 10 best- and worst-performing funds. It seems logical that the high-flexibility funds might make up a bigger percentage of both the winners and losers, because flexible managers are taking chances that will get them to stand out, one way or another. The numbers do not demonstrate that effect, however. Indeed, most of the very top winners and very top losers come from the low-flexibility camp. But this finding occurs primarily because there are more low-flexibility funds, thus more candidates for the top and bottom lists. Once this effect is scrubbed, the numbers are, once again, very similar. But Expenses Make a Difference Large Growth Large Blend Large Value Mid Growth Mid Blend Mid Value Small Growth Small Blend Small Value 13 23 –6 –103 56 –19 31 52 47 –52 –15 54 –124 –44 29 –52 –19 92 9 –12 –9 57 –78 –1 7 –80 –122 There is one area of significant differences: expenses. For several categories, the average expense ratio declines powerfully as one moves from high to moderate to low flexibility. For example, high-flexibility large-blend funds check in with an average expense ratio of 1.08, moderate flexibility registers 0.9, and low flexibility is at 0.71. A sharper case yet is with the mid-growth category, where the expenses cascade south from 1.83 to 1.35 to 1.19 as flexibility moves from high to low. This occurs for two reasons. First, lower-priced institutional funds are likelier than most funds to score as low flexibility. This is because the institutional marketplace, in general, has been unimpressed with arguments by mutual fund managers that they should have broad mandates. Instead, institutions tend to use funds that are tightly defined. Second, at least in some cases, funds that are highly flexible charge higher fees, because they are perceived (at least by their own managers) as adding more value. In summary, manager flexibility is an issue of choice for the advisor, not of best practices. Just as it is a matter of taste of whether to select funds that are quantitatively or qualitatively managed; that are headed by teams or by individuals; or whether to invest in boutiques or with major multinational fund families, it is also a matter of taste as to whether you prefer high- or low-flexibility funds. K John Rekenthaler is Morningstar’s vice president, research and new product development. Trailing Five-Year Returns, Relative to Category (3/31/08), in Basis Points Category Flexibility of Style High Moderate Low Large Growth Large Blend Large Value Mid Growth Mid Blend Mid Value Small Growth Small Blend Small Value 62 17 8 –72 46 6 21 4 –20 10 1 45 –23 –42 8 –102 79 88 –12 –16 –15 30 –52 –9 29 –62 –16 Trailing 10-Year Returns, Relative to Category (3/31/08), in Basis Points Category Flexibility of Style High Moderate Low Large Growth Large Blend Large Value Mid Growth Mid Blend Mid Value Small Growth Small Blend Small Value 7 –2 26 –193 –29 –34 –8 –15 0 –28 27 59 86 103 –9 –87 57 125 5 –9 –29 28 26 43 30 0 –59 MorningstarAdvisor.com 23 http://MorningstarAdvisor.com

Table of Contents Feed for the Digital Edition of Morningstar Advisor - Summer 2008

Morningstar Advisor - Summer 2008 Contents Letter from the Editor Contributors Inbox College Planning: Solutions and Concerns ETFs: The Next Chapter Engineering Financial Advice Investment Briefs Flexible vs. Style-Pure Managers: The Evidence Forging a New Commodity Index Work Your Way Through College Planning Sizing Up the Options Best and Worst 529 College-Savings Plans A 529 Travel Guide 10 Tax-Smart Tips for College-Savings Planning Global Dialogue How Sequoia Cranks Out Good Returns Year After Year The Many Layers of David Winters Living on the Edge Stocks to Buy Once a Decade With Munis Feeling the Pain, Some Opportunities Arise Health Care Provides Shelter from Economic Storm Help Your Clients Get More Out of Their Bond Portfolios Mutual Fund Analyst Picks 50 Most Popular Equity ETFs Undervalued Stocks Most Popular Variable Annuities New at Morningstar New on MorningstarAdvisor.com Closer to Fine

Morningstar Advisor - Summer 2008

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