(PUB) Morningstar FundInvestor

June 2 014

Morningstar FundInvestor

9

The opposing results suggested by sector allocation and stock selection fell right in line with our thesis on the difficulty of market-timing and the relative stability of stock-picking. We tried to combine the two ideas by next asking: What if we had picked the managers who ranked in the top half of the group by stock-picking but the bottom half by sector allo- cation? Doing so would eliminate managers who have received a boost from sector-allocation decisions—a source of excess return that has tended to be hard to repeat. Instead, it would isolate those managers and funds that have historically generated their results via stock-picking alone. Using those criteria, the results jumped to a 66% success rate. Figure 2 presents another dimension of the results by showing the average excess returns that each selected group delivered in the subsequent three-year periods. Funds with peer-beating returns over the past three years, for example, outpaced the index net- of-fees by an average of 50 basis points three years later. (The positive results are similar to the Morning- star small-value category’s slight topping of the index over the past decade.) Picking funds based on allocation or stock-picking rankings resulted in some- what worse or better outcomes, respectively, but picking the funds that relied primarily on stock-picking (funds that ranked in the top half of the group by stock-picking results but the bottom half by sector- allocation decisions) delivered a respectable average annualized excess return of 119 basis points.

Screening the M500 Within the M 500 , five of the nine actively managed small-value funds fell into the group that passed the top-half stock-selection/bottom-half sector-allocation screen, and we present them in Figure 3 .

Figure 3 M500 Small-Value Funds

Avg 3-Yr Ann Excess Returns in Subsequent 3-Yr Period

Morningstar Analyst Rating

Fund / Ticker

Diamond Hill Small Cap DHSCX

-1.4%

Œ

Fidelity Small Cap Value FCPVX

1.4%

•

Perkins Small Cap Value JSCVX

-3.2%

•

AMG Managers Skyline Special Eqts SKSEX ´

6.5%

Third Avenue Sm Cap Value TASCX

-1.9%

‰

Of the five funds, Chuck Myers of Fidelity Small Cap Value FCPVX (which is closed to new investors) tends to keep his sector weightings close to his benchmark’s, so by default, his source of added value has had to come primarily from stock-picking. The managers and teams at Diamond Hill Small Cap DHSCX , Perkins Small Cap Value JSCVX (closed), AMG Managers Skyline Special Equities SKSEX , and Third Avenue Small Cap Value TASCX , in contrast, frequently deviate from the Russell index’s sector weightings; all of them more or less do so based on where the most-attractive areas of the market take their portfolios. Finding the Stock-Pickers If sector-allocation decisions tend to randomly affect results (and, overall, even detract from returns), then separating out the managers who have bene- fited from those decisions essentially screens out managers who have had luck on their side. It’s one way to identify managers with strong returns who have gotten there with a preponderance of luck from those who have true, repeatable skill—the Warren Buffetts. That’s not to say that luck can’t benefit skillful managers as well, so this screen should be considered as only one input among many when selecting managers. But whether luck is fleeting or not, it’s certainly hard to predict, which makes focusing on stock-picking a promising alternative. œ Contact Janet Yang at janet.yang@morningstar.com

Figure 2 Added Value of Small-Value Funds

1.4

1.19

1.2

0.77

1.0

0.50

0.8

0.6

0.15

0.4

0.2

Return

Sector Allocation

Stock Selection

Sector and Stock

Average excess returns versus Russell 2000 Value Index over rolling three-year periods. Data from 04/2004 to 03/2014.