Morningstar Advisor - August/September 2011 - (Page 29)

we found that about 62% of diversified U.S. funds remained in the same category over a given five-year period. These variations are probably a function of available “exit routes”—there are more categories adjacent to the mid-cap style boxes than there are to small- or large-cap boxes, perhaps explaining why more funds switched out of the mid-cap categories than the others. In addition, success tends to attract investors which, in turn, begets asset growth, forcing a manager to adapt by investing in larger, more-liquid stocks. This could also explain why funds most often move higher in the style box and not lower. (The destinations of funds that left the small-value, mid-blend, and large-growth categories are shown in Exhibit 2.) We also found that the degree of change in a category can fluctuate over time. Exhibit 3, which appears on the next page, shows the percentage of diversified U.S. large-cap funds that began and finished a rolling five-year period in the same category. As is evident from the chart, it has become less likely that a large-cap fund will remain in the same category at the end of a five-year period. This is mainly due to fund companies culling many of the large-cap funds that they launched with abandon amid the late-1990s’ large-cap craze. Category changes can affect the way we evaluate a fund’s relative performance. That is, if funds are switching between categories with some regularity, then it stands to reason that peer groups will include funds that spent part of the period in a different category and exclude funds that spent part of the period in the category but didn’t finish in it. To illustrate, Exhibit 4 shows the historical category classifications of all funds that were categorized as mid-blend in May 2011 or had begun in the category in June 2006 before eventually leaving for a different category. Exhibit 1 Classification Changes: Percentage of funds that stayed, left, or died in Morningstar’s U.S. stock-fund categories. Median of Rolling Five-Year Periods: June 1996–May 2011 80% 70 60 50 40 30 20 10 All Large Blend Large Growth Large Value Mid Blend Mid Growth Mid Value Small Blend Small Growth Small Value Stayed Left Died For illustrative purposes only. Categories shown are not unmanaged and not available for direct investment. Past performance is not a guarantee of future results. Exhibit 2 Where They Went: Destinations of small-value, mid-blend, and large-growth funds that switched to another category. Median of Rolling Five-Year Period: June 1996–May 2011 120% 100 80 60 40 20 Large Blend Large Growth Large Value Mid Blend Mid Growth Mid Value Small Blend Small Growth Small Value Small Value Mid Blend Large Growth For illustrative purposes only. Categories shown are not unmanaged and not available for direct investment. Past performance is not a guarantee of future results. By definition, every mid-blend fund is a member of the mid-blend category by May 2011. But, as the chart illustrates, a number of mid-blend funds were members of different categories for meaningful portions of the five-year period ended in May 2011 before eventually switching into the mid-blend category. For example, in November 2008, about 13 of the 115 mid-blend funds were still members of categories other than mid-blend. These funds’ returns would be entirely included in the mid-blend category and excluded from the category that they formerly occupied. Conversely, there were 58 funds that spent at least part of the five-year period ended in May 2011 in the mid-blend category but finished the period in a different category. These funds’ returns would be entirely excluded from the mid-blend category and included in the category in which they finished the five-year period. MorningstarAdvisor.com 29 http://www.MorningstarAdvisor.com

Table of Contents for the Digital Edition of Morningstar Advisor - August/September 2011

Morningstar Advisor - August/September 2011
Contents
Contributors
Letter From the Editor
Simplicity and Design Matter
Do You Use ETFs Strategically or Tactically?
The Institutional Way
How to Analyze an ETF
Eyeing ETFs’ Next Chapter
Small-Cap/Large-Cap Flip-Flop?
Four Picks for the Present
Investment Briefs
Morningstar Investment Conference
Pitfalls of Peer Groups
A REIT Recovery, With a Catch
Turning Fund Distribution on Its Head
Here Come ETF Managed Portfolios
Circle These Picks Amid the Crop of New ETFs
ETF Analyst Favorites
Beware, the Accidental Portfolio Manager
It’s the Destination, Not the Vehicle
New Growth, Rooted in Experience
Better Ways to Look at ETFs
How to Better Manage Your Clients’ Future(s)
More Bargain Than Bubble
Cheap, Local, and On a Roll
Mutual Fund Analyst Picks
50 Most Popular ETFs
Undervalued Stocks With Wide Moats
First-Quarter Assets Hit an All-Time High
You Say You Want a Revolution?

Morningstar Advisor - August/September 2011