Morningstar Advisor - February/March 2011 - (Page 44)

Spotlight Play Your Stars By Jon Hale How the best active managers can play multiple positions in a diversified portfolio. Basketball has five defined positions, but coaches often like to put their best players on the court even when it requires players to take on hybrid roles that cut across the traditional positions. Taken together, the team will have the skills necessary to cover the court, but players are free to play their game, wherever that may take them. The team is taking advantage of the unique individual talents of its star players. We at Morningstar Associates think of this analogy when we use active managers to put together multimanager investment portfolios for clients. There are several defined positions in a well-diversified portfolio. In our diversified domestic-equity portfolios, for example, we want to cover the main positions of the Morningstar Style Box. One approach would be to simply select one manager—a pure position player—to cover each square of the style box. But if our goal is to put together the most successful team, we want to think more broadly about how to combine successful active managers in a way that allows us to benefit from their skill while still achieving the diversification benefits that come from covering the style box. Selecting the Best Players based on rigorous fundamental research that has stood the test of time and that we believe is repeatable into the future. We prefer managers who are willing to express in their portfolios the conviction they have in their process. In many cases, our preferred managers are those we’ve closely observed for years. Once we’ve selected our managers, we determine how we’re going to combine them in a portfolio. To do that, we first analyze the holdings of all the managers, plotting them in the style box. This gives us a style blueprint for each manager. What we typically find is that few active managers are truly pure position players, at least as defined by the style box. Most have holdings that plot into multiple squares of the style box. Moreover, those few who are pure players tend to be low-tracking-error, index-hugging managers who often have difficulty outperforming passive funds over the long run. They seldom are the stars. As an example, take a look at the style blueprints of four active large-cap mutual funds that are Morningstar Analyst Picks: Sound Shore SSHFX, Fairholme FAIRX, Selected American Shares SLADX, and Jenson JENSX. With 51% of assets in the large-growth style box, only Jenson has so much as a bare majority of its assets in the style box corresponding to its Morningstar Category. Style Blueprint Weight % .50 26250 11225 1210 0 Sound Shore Fairholme Lrg Mid Sml 31 8 0 Val 26 10 0 Core 25 0 0 Gro 27 26 4 Val 17 13 0 Core 0 13 0 Gro Lrg Mid Sml Selected American Jensen 14 4 0 Val 38 7 0 Core 33 4 0 Gro Lrg Mid Sml 0 0 0 Val 35 5 0 Core 51 9 0 Gro Lrg Mid Sml Data as of Dec. 31, 2010 Using this information in our portfolio-construction process, we can determine how much we need to allocate to each manager in order to hit our overall allocation targets. In so doing, we recognize that our best managers are contributing to several positions, but that, overall, our portfolio is achieving its diversification goals and doing so with managers who have proven they can use skill to add value. Assembling the Team To do this, we first determine which managers we want to employ. We like active managers who have a well-defined investment process To show how a diversified multimanager 44 Morningstar Advisor February/March 2011

Table of Contents for the Digital Edition of Morningstar Advisor - February/March 2011

Morningstar Advisor - February/March 2011
Letter From the Editor
First, Do No Harm
Do You Use Active or Passive Investment Strategies?
Best of Both Worlds
How to Build an Index
Accountable Investor
Nice Guys Finish First
Four Picks for the Present
Investment Briefs
A New Guardrail Against Risk
Tech Loosens the Purse Strings (a Bit)
It’s More About Costs Than Active or Passive
Play Your Stars
In Between Active and Passive
Selling Beta as Alpha
The Weighting Game, and Other Puzzles of Indexing
Leaving the Nest
Redefining Credit Risk
Another Vote for Market-Based Credit-Risk Measures
Big Opportunities in Small-Cap Stocks
Benchmarks? What Benchmarks?
Mutual Fund Analyst Picks
50 Most Popular ETFs
Undervalued Stocks With Wide Moats
VA Sales Slide, but Assets on the Rise
Indexing’s Lunatic Fringe

Morningstar Advisor - February/March 2011