Morningstar Advisor - February/March 2013 - (Page 61)

return of each asset class is assumed to be the return of a broad index. A number of mutual funds list an allocation to “other.” If a fund’s allocation to other was more than 20%, we removed it from consideration. allocation exhibited less risk than their average strategic policy portfolio benchmarks; however, the potential risk benefit decreases (and eventually disappears) the more tactical a mutual fund manager is. Our screens uncovered 458 funds for the analysis. Because holdings data is not available for each month for all funds, if data was missing for a month, we used the last available month’s allocation data as the assumed asset-class allocation for that month.2 These results are somewhat counterintuitive. One would expect that, in aggregate, market timing should not lead to excess risk-adjusted performance, because it is impossible for everyone to outperform a well-matched benchmark (unless all portfolio managers live in Lake Woebegon). A reason why these results suggest market timing has existed is because our approach doesn’t consider the actual assets in each strategy. While a fund’s assets are certainly important when considering, for example, the market-timing intelligence of mutual fund investors, it is less relevant when determining whether or not portfolio managers can add value through market timing. Higher Returns, Less Risk The results of both proxy tests were similar. The average outperformance against the policy portfolio was 14 basis points with a standard deviation of 0.69% for the three-proxy test. It was 20 basis points with a standard deviation of 0.84% for the sevenproxy test. The average excess risk was negative 9 basis points with a standard deviation of 0.51% for the three-proxy test. It was negative 6 basis points with a standard deviation of 0.54% for the seven-proxy test. These results suggest that in the aggregate the tactical changes made by portfolio managers have added value on both a return and risk basis (and, therefore, on a risk-adjusted basis, as well). Forty-eight percent of the funds tested had higher returns and less risk than the policy portfolio, while only 18% had lower returns and more risk. Another way to consider the returns is the average monthly outperformance of the mutual funds versus their respective portfolios. This provides us with some indication as to the ability of active managers to make quality timing decisions over different market cycles (Exhibit 4). (Because the results for the three-proxy and seven-proxy portfolios were incredibly similar, going forward we will only discuss the seven-proxy portfolio results to eliminate redundancy.) The excess return results also suggest that while some tactical asset-allocation decisions may add value, the more tactical a manager is, the less value an investor is likely to realize. The results for the excess standard deviation also fall along these lines. Historically, mutual funds that had fewer changes to their Over the time period of our analysis, the portfolios outperformed their seven-proxy portfolio benchmarks 52.42% of the time. There appears to be little relationship, however, between when actively managed portfolios outperform their respective proxy portfolios and the level of the S&P 500. Tactical asset allocators typically note that their objective is to miss the significant declines in the market while capturing some or all of the upside. These results show no evidence that this has actually occurred. Category-Level Results Our primary analysis compared the proxy-filled returns for each mutual fund against its long-term proxy average. This approach, therefore, “matched” the underlying asset-class exposures for each mutual fund to form a proxy that represents its average historical exposures to the market. It may be, however, that certain types of tactical funds, such as those that typically have higher allocations to equity, outperform those with less flexibility because they have a greater ability to change their portfolios. In other words, more conservative managers may not realize the same level of outperformance because they are constrained within certain equity allocation boundaries. To determine what effect the relative aggressiveness of the portfolio has on the ability of a manager to make quality tactical asset-allocation decisions, we put the funds into groups based on their primary Morningstar category. The primary category is defined as the category that the fund was classified most often during the period. Note that this grouping does not affect the way the returns are calculated or how performance is compared; it simply serves as a method to let us group funds based on their relative aggressiveness. Conservative-allocation funds typically have between 20% and 50% allocations to stocks; moderate-allocation funds have 50% to 70% allocations to stocks; aggressive-allocation funds 70% to 90% to stocks; and world-allocation funds have at least 10% of 2 This portfolio “replication” approach yields a coefficient of determination (R²) of 85.4% to the actual mutual fund monthly returns; a median coefficient of determination of 90.3% for the seven-proxy portfolios; an average coefficient of determination (R²) to the actual return of 84.2%; and a median coefficient of determination of 89.7% for the three-proxy portfolios. While the correlation of the proxy returns to the actual mutual funds are noted here to describe the historical similarity in the returns, the actual mutual fund returns were not used in the analysis because the goal of this research is determine the intelligence of the historical broad, tactical asset-class decisions made by mutual fund managers. MorningstarAdvisor.com 61 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

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