Morningstar Advisor - October/November 2012 - (Page 26)

In Practice Five Inconvenient Truths of Manager Research By Jeffrey Ptak And how to overcome them. In past issues, we’ve burrowed into the machinery of manager research. For example, we’ve examined the persistence of category rankings, the stability of peer groups, and the importance of firm stewardship, among other topics. But sometimes, all a manager researcher wants to do is dish a little. Forthwith, here are five bad habits, misconceptions, and inconvenient truths that, if not tawdry, can trip manager researchers like us in our quest to deliver value to clients, as well as some suggestions for overcoming them. three-year rolling net returns for every largeblend fund that’s existed over the past two decades ending August. Then, we grouped the funds into quartiles and tracked their performance over the subsequent three-year period. What we found is that there was a 24.7% likelihood that a top-quartile large-blend fund would repeat that feat in the subsequent three-year period and a 51.1% chance it would land in the top-half. This isn’t much better than you’d do choosing a fund at random. Many of us also tend to trot out relative-return rankings and “batting average” statistics to prove our manager-selection chops. But is a fund’s percentile ranking, or the consistency with which it has outperformed, really all that relevant when one can simply invest in an ETF targeting a similar area or plying the same style? For example, if a passive U.S. stock market index-tracking fund can generate better risk-adjusted returns than 85% of its largeblend category peers in the decade ending August, “top-quartile” isn’t all it’s cracked up to be. We should stop pretending it’s otherwise. Solution: Cost-screen more stringently, use in return-constrained or homogeneous areas. Quite a bit of research backs this up. For example, Russel Kinnel, who heads-up fund research at Morningstar, Inc.,wrote a widelycited study that found expenses were the most-predictive of several variables he examined. Thus, when ranking, screening by cost is a sensible approach. If ranking based on performance, use longer time periods, such as five years. When we tweaked our study to replace three-year rolling return rankings with five-year rankings, we found that the five-year rankings were a bit more predictive. It’s no silver bullet, mind you, but seemed to alleviate some of the problems with relying on three-year rankings alone. Finally, we ought to re-boot manager research to de-emphasize relative returns in favor of absolute performance. Nuanced as that might sound, it means rethinking the way many of us have traditionally selected managers. For example, cost-screening becomes far more important, as your opponent isn’t the other funds in the peer group, but a more-implacable foe—the costless benchmark. Slicing-anddicing into discrete categories or styles becomes more passé—the focus would shift to finding managers that have a clearly differentiated process and a durable advantage (in firm structure, culture, economics, or execution). 1 We act like peer-group rankings mean more than they really do. Manager researchers tend to make a big deal out of relative performance rankings. That’s not too surprising—they’re easy to measure and convey; plus, clients can grasp them without too much trouble. They’re also often part of the price of admission; i.e., you need a three-year record to, among other things, be a candidate in a search or get a performance ranking. The better you stack-up versus peers, the likelier you are to get a look from gatekeepers like manager researchers. So, three-year rankings matter, big time. But evidence suggests that they’re not very predictive. Take the popular U.S. largecap blend mutual fund category. We tallied up longer time periods, recommit to beating the benchmark, not the category average. Cost advantages tend to be sticky and, thus, are historically one of the few reliable sources of persistent outperformance, especially 26 Morningstar Advisor October/November 2012

Table of Contents for the Digital Edition of Morningstar Advisor - October/November 2012

Morningstar Advisor - October/November 2012
Letter From the Editor
Ill Communication
Do You Use Factor-Investing Strategies?
Practicing What She Preaches
How to Determine the True Price of ETFs
The Quant Factor
Managers Dispute the Death of Equities
Investments á la Carte
Investment Briefs
Five Inconvenient Truths of Manager Research
Health Care’s Outlook Clarifies
Exploring the World of Factors
Uncloaking the Alpha Machine
Factor Strategies Gain Footholds in Practices
Big Mo
Fitting Factors Into the Formula
Clients Have a Friend in Luther King
Less-Liquid Holdings Mean More-Solid Results
Retirement-Withdrawal Strategies Quantified
Amid Turmoil, Don’t Discount Foreign Equities
Our Favorite Mutual Funds
50 Most-Popular Equity ETFs
Undervalued Stocks With Wide Moats
Should I Stay or Should I Go?

Morningstar Advisor - October/November 2012