(PUB) Morningstar FundInvestor

8

Buy the Stock-Pickers and Avoid the Sector-Pickers Morningstar Research | Janet Yang

We then took three-year rolling results and essentially tried to answer this question: If we were to pick funds that ranked in the top half of the group based on the past three years of returns, allocation effects, or stock-picking results, what would be the chance that those funds would outpace the Russell 2000 Value Index three years later? Figure 1 displays the average success rates of all of those rolling three-year results.

Morningstar analysts often turn to attribution results when digging into a manager’s performance. The analysis typically compares a strategy’s returns with an index, dividing results between the portion of outperformance attributable to a manager’s sector- allocation decisions and the portion that comes from stock-picking results.While the former can often have a big effect on returns—avoiding financials stocks in 2008 has become a go-to example of this— there’s much academic and industry research that suggests it is very difficult to consistently make win- ning market-timing calls. Morningstar’s collective decades of experience analyzing performance suggest that manager’s stock- picking skills tend to have a degree of stability and persistence, though, and we wondered if there was a way to apply the essentially ex-post examination of a manager’s attribution results into an ex-ante method of finding future outperformers. Our research is still in its early stages, but the results so far have been promising. To look into the question, we expanded our analysis of attribution results from its usual manager-by-manager examination into a wider one that compared each fund’s attribution results with its peers’. We limited the analysis to the 10 years between April 1 , 2004 , and March 31 , 2014 , and looked only at the small-cap value universe. Smaller-cap stocks have generally outpaced their larger-cap counterparts over the past decade, while value- and growth-style small-cap funds have both roughly evenly outpaced those in the blend bucket. Choosing the small-value corner of the Morningstar Style Box, then, helped to prevent the results from being skewed by managers’ “cheating” via market-cap or investment-style deviations. We also made sure to include all distinct funds that exist- ed throughout the 10 -year period, as survivorship bias would otherwise likely positively skew the results.

Figure 1 Success Rates for Small-Value Funds

100

66 %

75

55 %

50 %

47 %

50

25

Return

Sector Allocation

Stock Selection

Sector and Stock

Percentage of funds that outpaced the Russell 2000 Value Index over rolling three-year periods. Data from 04/2004 to 03/2014.

Funds ranking in the top half of the small-value peer group based on the past three years of returns, on average, had a 50% chance of outperforming the index three years later; so at least in this case, past returns provided little to no help in picking funds that would do well in the future. Choosing funds with the strongest past sector-allocation effects seemed to actually provide negative information: Those with the strongest showing on that front, on average, ended up outpacing the index less than half the time three years hence. This goes back to the point about how difficult it is to make good sector bets. It also speaks to the fact that sectors rotate in and out of favor, so a fund that favors a couple of sectors will naturally have ups and downs that likely even out over time. Picking funds based on stock-picking skill, however, appeared to hold some promise. On average, managers that ranked in the top half of the small- value category based on three-year rolling stock-picking attribution later went on to beat the benchmark three years later 55% of the time.