Morningstar Advisor - June/July 2013 - (Page 24)

In Practice The Percentile Trap By Jeffrey Ptak When researching fund managers, put relative performance measures in their proper context. You can see it, but can you hit it? It’s a baseball adage, but for manager researchers like us, it’s the pivotal question— we know that “good” managers are out there, but can we find them before it is too late? The historical record isn’t terribly encouraging in this regard. Examples of remarkably successful manager researchers—be they investment committees, gatekeepers, or private investors—do not exactly abound. What’s the hitch? Well, manager researchers are human, after all. They chase returns; they misattribute outperformance; they rationalize underperformance; they get complacent; they dig in. That is, they act like the managers they’re paid to scout and monitor, whether they’re willing to admit it or not. In our shop, we’re hardly strangers to such mistakes, though we try our best to minimize them. That’s why, when we reflect on our process and its blind spots, we consider not just the choices we make but also the context. Are we using the right yardsticks? Do they tell the full story? Do we have the proper frame of reference? Inevitably, our analysis has led us to reconsider that most ubiquitous of managerresearch tools—category peer rankings. We’ve written previously about some of the quirks of peer groups (“Pitfalls of Peer Groups,” 24 Morningstar Advisor June/July 2013 August/September 2011). Our research found considerable flux within peer groups, with funds flitting between categories, raising questions about the substance of rankings themselves. We’ve also examined the fleeting nature of relative performance (“Performance Chasing, Evaluated,” April/May 2012), which tends to be mean-reverting (owing to stylistic biases, capacity constraints, “career risk,” or just plain luck). What we haven’t studied, however, is the convergence of the two and its implications on our ability to find successful managers in advance. Our Study We compiled rolling five-year net returns of all U.S. open-end mutual funds (existing and obsolete; oldest share-class only) that were members of the Morningstar large-value, large-growth, mid-blend, small-value, or small-growth categories on March 31 of any year from 2003 through 2013. We then ranked the funds within their peer groups based on trailing five-year returns. (Thus, we studied 11 distinct five-year periods: April 1998 to March 2003; April 1999 to March 2004; April 2000 to March 2005; and so forth.) We compiled the returns using a “category true” method. We rebuilt the peer groups based on their historical Morningstar category classifications, rather than working backward from their current classifications (which might not represent how a fund was categorized in the past). The peer groups that we assembled should closely approximate the peer groups that actually existed at the end of each relevant five-year period. In assembling the data, we sought to find out whether past top-quartile rankings predicted outperformance in successive five-year periods. Our Findings We found that unerringly consistent performance is rare: 40% to 50% of top-quartile funds promptly fell from the top quartile, on average, in the next consecutive rolling five-year period (Exhibit 1). That is, if a fund was top quartile in the five-year period ended March 2005, there was a roughly 50/50 chance that it would not be in the top quartile in the five-year period ended one year later in March 2006. A year further out, we found that only about one third of the original group of top-quartile funds remained. By the fifth year, almost none of the top-quartile funds were left. In short, top funds almost always fall from their perch. What became of these top-performing funds? We tracked the subsequent performance of the 45 large-value funds whose trailing five-year returns placed them in the category’s top quartile as of March 2003 (Exhibit 2). One year later (i.e., rolling five-year period ended March

Table of Contents for the Digital Edition of Morningstar Advisor - June/July 2013

Morningstar Advisor - June/July 2013
Letter From the Editor
Not Your Values
How Do You Use Alternatives for Clients?
Working to Build a Niche
How to Put Buffett’s Investing Philosophy into Practice
Sophisticated Strategies for the Masses
Investments á la Carte
Investment Briefs
The Percentile Trap
Defense Firms Will Stay Aloft
Beware the Lure of Diversification
Using Alternatives in Practice
Managed Futures and Cash Rates
The World Is Getting Grayer
Waiting to Pull Up Anchor
The Price of Managing Volatility
Let’s Get Back to Basics
Our Favorite Mutual Funds
50 Most-Popular Equity ETFs
Undervalued Stocks With Wide Moats
Mutual Fund Urban Myths

Morningstar Advisor - June/July 2013