Morningstar Advisor - April/May 2011 - (Page 28)

In Practice How We Improve Our Odds of Picking Outperformers By Jeffrey Ptak A study offers lessons for investors striving to add value through fund selection. We think that one of our biggest responsibilities as an investment manager is to properly set expectations. We want the advisors with whom we work to have confidence in our abilities yet also to understand the attributes of our investment philosophy that can have an impact on our short-term performance. This helps ensure that advisors share our longterm orientation, which helps us to execute the strategies on their clients’ behalf. In the course of having these discussions with advisors, the subject sometimes turns to what returns might be possible. Specifically, advisors seek to estimate a portfolio’s “excess returns” over a market cycle, which they define as the portfolio’s return less the benchmark return, often irrespective of risk. In this commentary, we present a framework to estimate the potential excess returns of various asset classes, as well as a hypothetical 65% equity/35% bond portfolio. We also draw on the findings of our study, as well as our perspective managing portfolios, to offer recommendations on how to improve the odds of selecting outperforming funds. Our Study Percentile rankings are easy to understand and uniformly apply. However, it’s not always clear how a given level of outperformance, expressed as a percentile ranking, might translate to excess returns. Thus, we set out to devise a framework for estimating the potential excess returns associated with various mutual fund percentile rankings. To that end, we compiled monthly returns for all U.S. open-end mutual funds in the following asset classes: domestic large cap, domestic mid-cap, domestic small cap, developed foreign stock, emerging-markets stock, investmentgrade bond, high-yield bond, foreign bond, real estate, and absolute return (excluding leveraged funds). To eliminate survivorship bias, we added the returns of merged and obsolete funds back to the dataset. The study covered the 20-year period from January 1990 to December 2010, encompassing more than 6,000 unique funds in all. Using the monthly data, we calculated rolling one- and three-year annualized returns for every fund in each asset class. We then calculated the 10th, 25th, and 50th percentile return breakpoints for every rolling period of each asset class. For example, within the domestic large-cap group, the 25th percentile return for the rolling one-year period ended July 2007 was 18.2%. For each class with a complete dataset, we calculated percentile returns for all 241 rolling one-year periods and 217 rolling three-year periods that make up the 20-year span. From there, we compared the 10th, 25th, and 50th percentile returns of each rolling period with the relevant index return. Returning to the previous example, we compared the 25th percentile domestic large-cap return for the rolling one-year period ended July 2007 with the Russell 1000 Index’s one-year return during the same period and calculated the difference. We repeated that exercise for every rolling period of every asset class, the only exceptions being rolling periods in which there were too few funds to calculate a meaningful percentile return. Finally, using the return data of the aforementioned asset classes, we calculated the excess return of a hypothetical 65%/35% portfolio for every rolling period for which complete data was available (1996 forward). To simulate the portfolio’s rolling excess returns at the 10th, 25th, and 50th percentiles, we multiplied the rolling excess returns we’d calculated for each asset class by weightings we assigned. (The weightings are based on asset-allocation guidelines set by Ibbotson Associates.) Our Findings There are a number of ways to estimate the excess returns of a diversified portfolio. In this study, we opt for an approach that we think is familiar to investors—percentile rankings. On the surface, what we found is unsurprising—the better the relative performance in an 28 Morningstar Advisor April/May 2011

Table of Contents for the Digital Edition of Morningstar Advisor - April/May 2011

Morningstar Advisor - April/May 2011
Letter From the Editor
The Debate That Matters Most
What Can the Mutual Fund Industry Do Better?
Cool Logic, Warm Intent
How to Start a Mutual Fund
Owner and Operator
Middle East Revolts Roil Oil Markets
Four Picks for the Present
Investment Briefs
How We Improve Our Odds of Picking Outperformers
Health Care Survived 2010, but Investors Want Proof
The Global Fund-Leadership Playoffs: Europe vs. the United States
U.S. Fund Investors Have It Good
U.S. Fund Firms Learn to Speak UCITS
Balancing Act
The Tamer Ride
Investors Lend a Hand
Healthy, Wealthy, and Wide
Foreign Funds That Win at Concentration
Mutual Fund Analyst Picks
50 Most Popular ETFs
Undervalued Stocks With Wide Moats
VAs Finish 2010 With a Solid Gain
Buying Good Funds, Poorly

Morningstar Advisor - April/May 2011