Morningstar Advisor - October/November 2012 - (Page 7)

Letter From the Editor Factors in the Real World Despite the research, you might not believe that an academic model and a computer can consistently identify and capitalize on investing factors that drive market outperformance. In the real world, after all, the market is full of unknowns and outcomes that a model cannot possibly consider. There also can be something reassuring about having an experienced, proven manager at the helm, someone you know who has studied the financial statements, scrutinized company managers, and determined intrinsic values. Or maybe you simply believe that it’s a fool’s game to try to beat the market, so why even bother trying. Whatever your investing views, we think that there are some fascinating, practical lessons to learn from factor investing. You might disagree with Cliff Asness when he argues that factor strategies build the most efficient portfolios, but when you hear him discuss that the reason factors work is because they are essentially rules by which to weight stocks to take advantage of the world’s irrationalities, you see the importance of having a sound investing plan and sticking to it through thick and thin. It is from this standpoint that we approach factor investing in this issue. A good place for readers to start is our Morningstar Conversation with Asness and Rob Arnott, moderated by contributing editor Paul Justice (“Fitting Factors Into the Formula,” Page 56). Both are quants who have successfully applied factor-investing concepts in the marketplace. And both are able to clearly—and entertainingly—discuss which factors are important in investing and why. Next, move on to our Spotlight section. Gideon Magnus, a researcher at Morningstar, covers the academic beginnings of factor investing—what factors are, what they tell us, and why we should care (“Exploring the World of Factors,” Page 36). Analyst Samuel Lee then writes about what this means for active fund managers (“Uncloaking the Alpha Machine,” Page 40). The question for active managers, Lee says, is: If most of an active manager’s return can be explained by factors, which research has shown, why shouldn’t investors ditch a layer of management and simply own the factors directly? Because of people like Asness and Arnott, that is easier than ever. Cheaper and cheaper factor-mimicking funds will continue to come to market, giving investors more options and putting even more pressure on active managers to justify their fees. We asked fund analyst Shannon Zimmerman, an avowed fundamental investor, to give us his take on perhaps the most intriguing of all the factors: momentum (“Big Mo,” Page 46). He’s not yet sold all the way on momentum’s real-world performance. Yes, momentum has shown to be consistent and powerful, but he wonders whether other attributes are playing role—factors that are more, daresay, qualitative than technical. I have a feeling that many advisors share Zimmerman’s overall point—that factors such as momentum certainly exist, but we need to keep asking questions to fully understand exactly why. And by asking these questions, we will learn more about investing. I’d love to hear your thoughts. Let me know via Twitter. Jerry Kerns Follow Jerry on Twitter @ jerrykerns MorningstarAdvisor.com 7 http://www.MorningstarAdvisor.com

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

Morningstar Advisor - October/November 2012
Contents
Contributors
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