Morningstar Advisor - February/March 2012 - (Page 30)

In Practice Exhibit 4 Rolling Three-Year Sharpe Ratios vs. 100% Vanguard Balanced: The average tactical fund would have conferred better risk-adjusted returns in relatively few rolling three-year periods compared with Vanguard Balanced. 3-yr. Rolling Sharpe Ratio Beginning Jan. 1, 2001, Through Dec. 31, 2011 0.1 0.05 0 –0.05 –0.1 12/2003 12/2004 12/2005 12/2006 12/2007 12/2008 12/2009 12/2010 90% VBINX/10% Tactical 80% VBINX/20% Tactical 60% VBINX/40% Tactical 12 of the 44 funds were merged or liquidated post crisis, presumably because they missed out on a huge portion of the gains. Those funds lacked results for the full post-crisis period, so they were excluded from the data used to calculate the 46% upside-capture ratio.) Performance issues notwithstanding, the last question we examined was whether, in general, an allocation to tactical funds could have other, salutary diversifying properties. That is, could they help, perhaps because of their professed focus on downside, to make portfolios more efficient? (In our previous study, we didn’t examine this question largely because so many of the funds hadn’t existed for a full market cycle, making the peer group’s diversification potential difficult to assess.) To evaluate that question, we calculated the monthly average returns of all funds in our peer group, including merged and liquidated funds, for the 10-year period ended Dec. 31, 2011. We then combined that tactical-fund average return stream (“tactical average”) with the monthly returns of the Vanguard fund under several hypothetical portfolio scenarios: r r r 90% Vanguard fund/10% Tactical average 80% Vanguard fund/20% Tactical average 60% Vanguard fund/40% Tactical average From there, we calculated the rolling threeyear Sharpe ratios of these hypothetical portfolios and compared them with a portfolio that invested exclusively in the Vanguard fund, tallying up the differences (the hypothetical portfolio’s Sharpe ratio minus the Vanguard fund’s Sharpe ratio, for each rolling period). What we found was that an allocation to the average tactical fund—be it 10%, 20%, or 40%—conferred better risk-adjusted returns (as evidenced by a higher Sharpe ratio) in fewer than one third of the 97 rolling three-year periods (Exhibit 4). This is striking, given that the 10-year period in question saw fairly tepid U.S. large-cap equity returns, a trend that ostensibly should have made the Vanguard fund—which skews heavily to such stocks in its equity sleeve—easier to complement. Conclusion we also found, in a simulation of various hypothetical portfolios over the 10-year period ended Dec. 31, 2011, that the average tactical fund would have delivered little incremental diversification. To be sure, several tactical funds, such as PIMCO All-Asset PASAX and GMO Global Asset Allocation GMWAX, have continued to enjoy notable success. But most of the funds that we evaluated were inconsistent performers at best. Thus, it stands to reason that investors seeking to add ballast to a portfolio should be very selective in considering tactical funds. Our research suggests that, in all but a few instances, they would be better served simply hiking their portfolio’s bond stake or utilizing alternatives like precious metals. K Jeffrey Ptak, CFA, is president and chief investment officer of Morningstar Investment Services. About Morningstar Investment Services Morningstar Investment Services brings fee-based advisors the resources of an independent, experienced investment team. The team’s range of customizable stock, ETF, and mutual fund portfolios is guided by proprietary methodologies and leverages the well-recognized research of Morningstar, Inc. For more information, visit http://global.morningstar. com/mis or call +1 877 751-4208. In extending our study of tactical mutual funds through Dec. 31, 2011, we found that tactical funds generally struggled to deliver competitive risk-adjusted returns when compared with a traditional balanced fund. With a few exceptions, they gained less, were more volatile, or were subject to just as much downside risk as a 60%/40% mix of U.S. stocks and bonds. These findings largely reaffirm our earlier study of tactical funds. In addition, 30 Morningstar Advisor February/March 2012 http://www.global.morningstar.com/mis http://www.global.morningstar.com/mis

Table of Contents for the Digital Edition of Morningstar Advisor - February/March 2012

Morningstar Advisor - February/March 2012
Contents
Contributors
Letter From the Editor
Make a Difference Stories, Not Debates
How Concerned Are You About Europe?
Analytical and Independent
What to Ask When a Fund Manager Leaves
Past, Present, Future
Have Financials Gotten Cheap Enough?
Four Picks for the Present
Investment Briefs
Tactical Funds Miss Their Chance
Specialty Retail: Ad Hoc Opportunity
How Europe Is Making Its Crisis Worse
Impact on U.S. Economy Will Be Minimal
European Banks: Bargains or Value Traps?
Don’t Count the Euro Out Yet
Europe on the Brink
GoodHaven Realizes Its Vision
How Index Trading Increases Market Vulnerability
Nonlisted REITS: Handle With Care
Safety Picks for the Many Moods of Mr. Market
On the Prowl for Large- Blend Index-Beaters
Our Favorite Mutual Funds
50 Most Popular ETFs
Undervalued Stocks With Wide Moats
The Math That Matters

Morningstar Advisor - February/March 2012