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How the Best Large-Cap Managers Rise Above the Rest

Attribution analysis reveals the stocks and sectors that drive (or hold back) mutual funds' returns.

Karen Dolan, 10/27/2009

Bill Miller (Legg Mason Value LMVTX) got hurt owning stocks now resting in the financial company graveyard, Bruce Berkowitz (Fairholme FAIRX) cashed in on energy, and Will Danoff (Fidelity Contrafund FCNTX) scored big with Google GOOG. These are some anecdotal explanations for the performance of those funds, but a handy tool called attribution analysis allows investors to systematically dissect a fund's portfolio to help explain performance. Combining attribution with qualitative knowledge of managers' portfolios and strategies uncovers a complete picture of the underlying sources of their returns.

Attribution analysis is commonly used by institutions to help explain which sectors and stocks contributed to a fund's performance. Morningstar recently added this capability to its institutional software tool, Morningstar Direct, and Morningstar's analysts plan to start harnessing its insights as we dig into fund performance. For our first foray into attribution analysis, we decided to look at large-cap funds that are Morningstar Analyst Picks and that have the S&P 500 as their benchmark. The large-cap universe is a notoriously competitive and difficult place for funds to gain an edge, making it a prime candidate for deeper study of what factors explain performance. To tune out the noise that comes with short periods, we looked back over the past five years ended June 30, 2009, and compared each fund with the S&P 500 to see which stocks and sectors helped and hurt its performance. We dropped the index and enhanced-indexed picks from the study as well as active funds that use a benchmark other than the S&P. Finally, we excluded Clipper Fund CFIMX because it changed advisors in the middle of the period under study. Our short list focused on 18 actively managed funds.

We started off our analysis by comparing each fund's sector weightings with the index and then drilled down to see which stocks had the biggest effect on the fund's results. We then measured how much value (in percentage terms) over the index the managers added in their selections of stocks and sectors.

There are a few limitations worth noting. Morningstar's attribution analysis is based on public quarterly portfolio data and does not consider every trade a fund made, making it an imperfect tool for precise accounting of a fund's successes and failures. Therefore, the reliability of our analysis declines for higher-turnover funds such as Brandywine Blue BLUEX and Mainstay ICAP Select Equity ICSLX. In addition, we don't know which came first, the stock choice or the sector theme, so we can't be too precise about where one ends and the other begins. (View the related graphic here.)

Stocks, Not Sectors, Rule
Most managers of our large-cap Analyst Picks focus on picking stocks as opposed to making big sector bets or market-timing calls.

Fourteen out of the 18 funds we examined succeeded over the past five years by holding large positions in stocks that outperformed the S&P 500.

Fairholme bet big on Canadian Natural Resources CNQ, for example, and locked in gains as the stock shot higher while sitting in the portfolio's top position. Berkowitz drastically trimmed the fund's stake in Canadian Natural Resources at an opportune time. It ended up tanking in the summer of 2008 not long after Berkowitz trimmed the position to less than 5% from more than 15%. Although not as concentrated as Fairholme, Vanguard Primecap VPMCX struck it big with Potash POT and Monsanto MON. Just as important as what they did own was what they avoided. Sequoia SEQUX, for example, came up big for its stock selection. It didn't have any huge wins on individual stocks but managed to avoid the big disasters.

The funds that score poorly for their stock picks were sunk by some of their highest-conviction holdings. For example, Oakmark Select's OAKLX Washington Mutual position overwhelmed all else over the past five years. Its losses on WaMu mounted as the fund kept more than 10% and sometimes more than 15% in that one stock, which went on to lose almost all of its value by the time the fund sold it. The danger of its concentration is especially clear when you compare Oakmark Select's performance and attribution results to Oakmark OAKMX, which is also managed by Bill Nygren and follows a similar albeit less-concentrated approach. Select's WaMu losses far outweighed gains in other stocks such as Yum Brands YUM and McDonald's MCD. Other Analyst Picks were hurt by big holdings. General Motors GM and Dell DELL weighed heavily on Longleaf Partners LLPFX. Selected American Shares SLADX and Davis New York Venture NYVTX were stung by flailing financials such as American International Group AIG and Citigroup C.

Sector Bets Came in Second
Overall, sector selection was less important of a driver than stock selection for these picks. Some picks leaned into stronger sectors and avoided weak ones while others leaned the wrong way with media, financial, and energy stocks. None of our picks failed or shone because of their technology and health-care stocks. Yet these two sectors represent a large and growing portion of our pick portfolios, so we'd expect them to be a bigger driver of returns in the next five years than they were in the past five. Energy and financials were more important to a fund's bottom line. Combined, those two sectors made up 30% of the S&P 500 over the past five years on average, and returns in those sectors were very bumpy, so it's no surprise that positioning in energy and financials went a long way in explaining the performance of most of our picks, for better or for worse. Sound Shore SSHFX, Fairholme, and Longleaf Partners gained the most ground by avoiding financials. All three funds missed the biggest blowups in the financials sector, and the latter two benefited from parking less money in the sector overall. Selected American Shares did a decent job picking stocks in the financials sector, but its heavy sector weighting hurt.

Energy proved to be a wild card for some funds and a disaster for others. Mainstay ICAP Select Equity and Columbia Value & Restructuring UMBIX particularly benefited from their energy positionings. Interestingly, energy wasn't quite the boom or bust we would've thought for two funds: Fairholme and Weitz Partners Value WPVLX. Fairholme did navigate energy well, but its avoidance of financials was far more important to its returns, by many multiples. Weitz Partners Value suffered for not owning energy early on, but energy swooned last year and the fund's financial- and consumer-services bets cost the fund more.

And the Prize Goes To . . .
Vanguard Primecap, Fairholme, and Main Stay ICAP shone the brightest for both sector and stock selection. (View the related graphic here.)

These funds navigated a rapidly changing environment well, which showed up as added value for a number of different sectors and stocks.

Five-year attribution gives an interesting snapshot, but it doesn't tell the complete story for the picks. Our picks (with the exception of Jensen Fund) have all posted exceptional returns versus the S&P 500 under their managers' watch. Even those funds that didn't score as well in our attribution analysis still possess some winning combination of strategy, stewardship, management, low costs, and a long history of success.

Karen Dolan, CFA, is Morningstar's director of mutual fund analysis. Ben Alpert, CFA, contributed research to this article.

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