Morningstar Advisor - Winter 2008 - 45

Major Indexes Don’t Tell Whole Story The importance of paying attention to style can be seen in these historical Morningstar Market Barometers. Although “the market,” as measured by S&P 500, lost 9.1% in 2000, for example, investors in the value and blend areas made money. Large Large Large +0.6 –6.8 -5.2 Value 1999 Dow S&P Nasdaq +17.8 +1.9 +16.7 Blend +42.6 +52.5 +46.0 Growth +5.7 +24.6 +18.7 Value 2000 Dow S&P Nasdaq +4.2 +14.8 +23.2 Blend –33.5 –11.1 –12.1 Growth –3.4 +5.1 +18.6 Value 2001 Dow S&P Nasdaq –14.4 +6.1 +14.6 Blend –29.1 –21.6 –12.9 Growth Graphs show calendar-year returns %. +27.2 +21.0 +85.6 Mid Small –4.9 –9.1 –39.3 Mid Small –5.4 –11.9 –21.1 Mid Small you have to be somewhat flexible to allow them to go where they see opportunities. JM: If we’re looking at a portfolio of funds, we take the same approach. We want to use the best managers that get us to our overall mix that we’re trying to get. So if we have a couple of go-anywhere managers and combining them gets us to the mix we want, then we’ll use them. Essentially, what we want to do is get to that mix using the best, highest-quality managers we can find. Do you use a single manager for a particular area, or do you divide the allocation among multiple funds? JM: We have no real preference; we just want strategy. We don’t necessarily use the same large-cap growth or large-cap value fund across all our models. We may use one fund that’s a little bit more conservative for our conservative models, and we may use a more-aggressive, more-concentrated fund for our aggressive models. Let’s talk about range within a style. Individual investors might assume all large-cap growth funds are the same, but there are huge differences within a specific area of the style box. BH: There are so many different flavors of how these managers approach investing. Are you talking about Richie Freeman or Tom Marsico—somebody who’s going to buy more aggressive-type growth stocks? Or are you talking about Larry Puglia at T. Rowe Price— somebody who takes a classic growth approach? We look at placement in the style box over time. We look at things that go into that style box determination, such as price multiples, and also things like upside capture over time, some quantitative measures, as well as qualitative pieces—all to help us determine how these two managers might go together. You don’t want to buy the same thing twice. BH: Another thing we look at is how their to get to the overall mix however we can. BH: Sometimes we divide it among managers. In the value space, for example, we may have a manager who’s more absolute value oriented, versus a “relative-value” manager, because the relative value manager is more likely to have more exposure to core and growth stocks, so we’re almost using that manager as more of the core. But we have five kinds of model strategies, ranging from aggressive growth to conservative, and we may also select different managers based on the risk profile of that growth and value, and when you bring in the fact that some managers may be more all-cap or go-anywhere in nature, it’s hard. Where does that fund really fit within the style box? With a lot of funds, it’s somewhat hard to put a precise label on them, so I think you first want to understand the investment strategy and how the manager selects securities, how they manage risk, what their biases tend to be over time. That’s why it’s important to look at the overall portfolio structure within the style box framework. JM: When you get to an asset level where you need to add managers and want to pair, for example, two large-cap growth funds that aren’t exactly the same. As Bill said, the key point is really knowing the fundamentals of holdings overlap. If you’re combining two funds, you want to make sure that there are some diversification benefits. How much style leeway do you give managers in terms of rebalancing? JM: We put bands around where we are. We have prospectus bands that we have to abide by, in terms of the broad asset classes. For style exposure, it’s a little bit less rigid, but we do have bands around it—plus and minus 5% to 10%. We’re pretty loose with it relative to our target. The question becomes, do you let a good manager that you have a lot of faith in continue to run and continue to do MorningstarAdvisor.com 45

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Morningstar Advisor - Winter 2008

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