(PUB) Investing 2015

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Buy Stock-Pickers, Avoid Sector-Rotators, Part 2 Morningstar Research | Janet Yang

Exhibit 1 Success Rates for Lg-Growth Funds Vs. Russell 1000 Growth Idx

30

28 %

26 %

24

25 %

23 %

23 %

18

12

About a year ago, we introduced Morningstar FundInvestor readers to the initial findings from Morningstar’s research on using peer attribution to screen and select funds. Starting with the small- cap value universe, we took a look at if strong sector-rotation or stock-selection skills in the past led to better performance in the future. The results fell in line with expectations: Morningstar analysts have anecdotally observed that stock-selec- tion skill tends to be more stable than sector-rotating dexterity, and peer-attribution data supported the hypothesis. While the latter can markedly affect returns in any given period, academic and industry research has shown that it’s difficult to consistently make additive market-timing calls. Picking managers based on their past stock-picking attribution results led to higher returns and better success rates than picking them based on their sector-attribution rankings. We’ve since expanded the research into the large- growth stock space, a category that’s had a strong run in the past 10 years. Using the same methodology that was used for the small-value findings, we looked at all distinct large-growth funds that existed in the 10 years from July 1 , 2005 , to June 30 , 2015 . We then used three-year rolling results to answer the ques- tion: If we picked funds that ranked in the top half of the group based on the past three years of either returns, allocation effects, or stock-picking results, what is the chance that those funds would outperform the Russell 1000 Growth Index three years later? Exhibit 1 shows the average success rates of those rolling three-year results. The numbers don’t look impressive upon first glance, but they require some perspective. The Russell 1000 Growth Index has been one of the toughest indexes to beat of late. During the past 10 years, using three- year returns that roll forward every three months, the

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Return

Sector Allocation

Stock Selection

Sector & Stock

All

Data from 07/2005–06/2015. Average percentage of funds that outpaced the Russell 1000 Growth Index over rolling three-year periods.

large-growth category average has never topped the index. On average, only 23% of all large-growth funds outpaced the index over those rolling three years. In that context, the success rates in Exhibit 1 look somewhat less dire for active managers, which are by and large the majority of constituents within the large-growth group. Funds that ranked in the catego- ry’s top half based on the past three years of returns, on average, had a 25% chance of outperforming the index three years later. That’s slightly better than the 23% chance of picking a fund at random. Picking funds with the best past sector-allocation effects produced success rates similar to random chance, adding to the evidence of the difficulty of making good sector bets. While some funds that tend to favor certain sectors may see strong sector results at times, those gains often get wiped out in other periods, commensurate with how certain sectors come into and out of favor over time. Meanwhile, funds with strong stock-picking results had a better chance—at 26% —of coming out ahead of the index. If sector rotation doesn’t help but stock selection does, we tried to combine the two concepts by asking: What would have happened if we picked managers that ranked in the top half of their peers by stock- picking but in the bottom half by sector allocation? This scenario excludes funds receiving boosts from seemingly unsustainable strong sector decisions and instead homes in on those that have had to rely primarily on stock-picking. Under this scenario, the success rate increases to 28% .