Morningstar Advisor - December/January 2012 - (Page 27)

norm, whether measured by “beat rate” or excess return generated. Putting aside questions of whether the pendulum has swung too far, our research finds that active-management beat rates tend to be fairly mean-reverting, with periods of greater success eventually begetting slumps, and vice versa. This has implications for those weighing the role of active and passive management in a portfolio, especially considering the binary, either/or way such decisions are often made. Indeed, our research suggests that trends in the relative success, or futility, of active management should inform such decisions. For example, in assembling an active/passive portfolio, one would ordinarily consider an asset class’ efficiency when deciding between active and index funds. Typically, investors opt for index funds in areas that are less hospitable to active managers and actively managed funds in less-efficient realms. However, given evidence that active management success tends to be mean-reverting, in aggregate, it could also be useful to assess recent beat rates in various asset classes, adjusting one’s commitment to active managers accordingly (that is, bigger commitment to areas with low beat rates, lower to those with unusually high beat rates). Of course, it remains difficult to consistently pick successful active managers, even from areas that have experienced unusually low beat rates. For those seeking to exploit mean reversion in active-manager success, the challenge thus becomes making it investable— giving investors the opportunity to “bet” on (or against) the success of a group of active managers, without courting the risk of selection errors (picking a manager who underperforms within a group that outperforms as a whole). While such products do not currently exist, these sorts of innovations could help to reduce the influence that perception. K Jeffrey Ptak, CFA, is president and chief investment officer of Morningstar Investment Services. Exhibit 1 U.S. Stock Funds Beat Rates: Active-management beat rates show periods of success eventually begetting slumps, and vice versa. Rolling 36-Month Periods: November 1996–October 2011 Beat Rates Large-Cap Large-Cap (Avg) Mid-Cap Mid-Cap (Avg) Small-Cap Small-Cap (Avg) 0.8 0.6 0.4 0.2 10/99 10/00 10/01 10/02 10/03 10/04 10/05 10/06 10/07 10/08 10/09 10/10 10/11 Exhibit 2 U.S. Large-Cap Funds, Excess Returns by Percentile: Excess returns at one and two standard deviations were larger in the past. Rolling 36-Month Periods: November 1996–October 2011 Excess Returns (%) 97.5th Percentile 84th Percentile 50th Percentile 16th Percentile 2.5th Percentile 25 20 15 10 5 0 –5 –10 –15 –20 10/99 10/00 10/01 10/02 10/03 10/04 10/05 10/06 10/07 10/08 10/09 10/10 10/11 Exhibit 3 U.S. Large-Cap Funds Beat Rates: Active managers show better success if beat rates use the “most recent” method. Rolling 36-Month Periods: November 1996–October 2011 Beat Rates Most-Recent Most-Recent (Avg) Rolling Rolling (Avg) 0.8 0.7 0.6 0.5 0.4 0.3 0.2 0.1 10/99 10/00 10/01 10/02 10/03 10/04 10/05 10/06 10/07 10/08 10/09 10/10 10/11 MorningstarAdvisor.com 27 http://www.MorningstarAdvisor.com

Table of Contents for the Digital Edition of Morningstar Advisor - December/January 2012

Morningstar Advisor - December/January 2012
Contents
Contributors
Letter From the Editor
Seduced by Complexity
Is China Exposure Important for a Portfolio?
A Niche Built on Trust
How to Find Your Client’s Investment Style
Taking the Long View
Consensus on Europe Elusive
Four Picks for the Present
Investment Briefs
Is Perception Reality for Active Managers?
Be Alert for Basic-Materials Bargains
Investment Boom Unsustainable
Digging Moats in China
Where China’s Domestic Companies Stand to Benefit
Arising Opportunities
China Strong Long Term
From Currency Manipulation to International Acceptance
The Keys to China’s Fortune
Wedgewood’s Lessons Pay Off
Reading the Evidence on Indexing
Scouting for Investments Abroad
Yield, Please (Hold the Europe)
Mutual Fund Analyst Picks
50 Most Popular ETFs
Undervalued Stocks With Wide Moats
China Fund Managers Eat Elsewhere

Morningstar Advisor - December/January 2012