Morningstar Advisor - February/March 2013 - (Page 37)

alternatives that charge fees and incur trading costs—in other words, indexes that investors could actually buy. I compared the return of the average actively managed fund in each category with that of the average index fund in each peer group. Most investors, however, don’t want to hire the average active manager; they use some criterion to find who they believe will be above-average managers. I also looked at the average actively managed Morningstar 500 U.S. stock fund in each category versus its typical passive rival. The Morningstar 500 is a reasonable proxy of what’s left over after an investor applies rudimentary screens to the entire fund universe. It’s not exactly the image of the typical above-average fund, but it sifts out most of the dross. The results, as of Sept. 30, weren’t much different from other active/passive scorecards: The index funds won in most categories and time periods. The typical active U.S. equity fund lagged the average index fund by about 1% in its peer group in most of the nine squares of the Morningstar Style Box for the trailing one-, three-, five-, and 10-year periods through the end of the third quarter of 2012. Active funds won in no more than three of the boxes in any one period, though active mid-value funds edged their index counterparts in every time period and small-value active funds won in the three-, five-, and 10-year periods. Here are two theories on why mid- and small-value managers fared well. Much of the past decade favored smaller-value stocks, which were relatively out of favor in the late 1990s. Also, many actively managed funds that don’t limit themselves to mid-value stocks, such as Delafield DEFIX and FPA Capital FPPTX, end up in the category because, on average, the portfolios produced by their flexible strategies map to the mid-value style box area. Still, some stricter actively managed mid-value funds, such as T. Rowe Price Mid-Cap Value TRMCX and Perkins Mid Cap Value JMCVX, also have done well. Such funds helped the average active Morningstar 500 U.S. equity fund do better than the broader active manager average against the typical index fund over the past decade. In the 10-year period ended Sept. 30, the typical actively managed Morningstar 500 U.S. stock fund dominated. It beat the average index fund in eight of nine style box categories. Passive funds prevailed only in large growth over this period. The average actively managed Morningstar 500 domestic-stock fund struggled over shorter periods. In the categories and time periods in which it lagged, the typical Morningstar 500 fund trailed by 1.3%, a bit more than the broader active fund average. This snapshot of past performance doesn’t predict future results, but it shows why investors have flocked to passive investing vehicles in recent years. There is, however, some hope for active managers in the 10-year performance of the average Morningstar 500 active domestic-stock fund. It lends some credence to the contention that, while it can be challenging to pick actively managed funds that beat rival index funds, following reasonable selection criteria and exercising patience can improve your odds of beating the indexes over the long term. Patience is vital. There are many actively managed funds that have beaten their indexes over the 10-year period but have lagged, sometimes by considerable margins, in one or more of the shorter periods. Achieving long-term success with funds like Dodge & Cox Stock DODGX and Diamond Hill Small Cap DHSCX requires enduring fallow periods. Don’t Settle for Average If you bought and held an appropriate mix of index funds, you’d help your odds of avoiding self-destructive behavior and reaching your investment goals. You need not be doomed, however, if you did the same thing with a set of low-cost, competently managed active funds, which despite Swensen’s blanket dismissal, do exist. The average actively managed mutual fund, like the average American, can look pretty gross. It charges higher fees than passive funds for subpar returns with more volatility and tax headaches. But just as not every American is an obese, soft-drink swilling couch potato, not every actively managed fund is a bloated, risky, shareholder-gouging mediocrity. You can increase your odds of success, though by no means guarantee it, by setting very high standards for selecting actively managed funds and sticking with them. Morningstar analysts have long done so, first with our Fund Analyst Picks and now with our new qualitative Analyst Ratings, which both focus on funds with experienced managers, proven strategies, responsible parent companies, reasonable fees, and long track records of success. We call these criteria the five Ps: People, Process, Parent, Price, and Performance. Our studies have shown that our Fund Analyst Picks have done well over time, and we’re confident it will also hold true for the Analyst Ratings, which have supplanted the picks. Don’t take our word for it, however. Indexing’s greatest evangelist, Bogle himself, delineated similar standards for selecting successful active managers in the inaugural 1985 annual report of Vanguard Primecap VPMCX. In it, Bogle said Vanguard hired Primecap because of its people, philosophy, portfolio, and performance. Those criteria have been the basis for Vanguard’s approach to selecting subadvisors for actively managed funds for years. It’s tough to beat low-cost index funds. But just as it was wrong to deride passive investing as settling for average results, it’s a mistake to equate all active funds with the average active fund. K Daniel Culloton is a contributing editor and associate director of active funds research with Morningstar. MorningstarAdvisor.com 37 http://www.MorningstarAdvisor.com

Table of Contents for the Digital Edition of Morningstar Advisor - February/March 2013

Morningstar Advisor - February/March 2013
Contents
Contributors
Letter From the Editor
Social Media, the Old- Fashioned Way
Do You Use Active Strategies?
Youth Appeal
How to Buy the Unloved 2013
Morningstar Managers of the Year
Investments á la Carte
Investment Briefs
Approaches to Absolute-Return Investing
In Agriculture, It’s Good to Be Strong
Yes, There Are Good Active Funds
The Decoupling
Where It Could Pay to Be Active
The Active Fund That Defies Obsolescence
The Epitome of an Active Manager
Lines of Communication
The Existence of Market Timing ‘Intelligence’
A Route to Commodities that Bypasses the Futures Market
Best Positioned for Health-Care Reform
Diversified Stock Funds That Earn Their Stars
Our Favorite Mutual Funds
50 Most-Popular Equity ETFs
Undervalued Stocks With Wide Moats
A Twisted Debate

Morningstar Advisor - February/March 2013