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A Multiple-Lens Approach to Analysis

A series of indexes can bring market trends into sharp focus.

Don Phillips, 04/01/2009

With the recent mania to create investable indexes for ETFs, it's easy to lose sight of the utility of indexes as analytical tools. A 20-stock "index" of companies linked to some trendy cause or faddish investment play may be tempting to license, but it has limited use as a research tool. Yet the original purpose of indexes was analytical--to understand whether the market was up or down, to identify trends in market direction, and to be able to assess the relative performance of funds against an objective benchmark. When properly constructed, an index can facilitate a better understanding of investment activities. It can be a lens that brings investment issues into focus, providing a framework that allows for better analysis. While no one lens will explain all markets, a series of lenses can forge a valuable tool kit for investment analysis.

Stylish Lenses
Creating such a series has long been a goal at Morningstar. The most noted examples have been the Morningstar Style Indexes, which really are a combination of two lenses--style and capitalization. As seen through the Morningstar Market Barometer, a heat map version of the Morningstar Style Box that shows strong and weak performance in shades of green and red, the style lens helps explain performance in years like 1999, a supposed bull-market year, and 2001, a supposed bear-market year.

Looking at these years through a broad market lens, an investor would conclude that with its 21% return, 1999 was a great year and that 2001, and its negative 11.9% return, was a bad year. Indeed, that's the conventional wisdom. Many market commentators still refer to the late 1990s as a time when all an investor had to do was throw money at the market to make money. Similarly, many say that there was no way to make money once the bear market began.

If an investor looks at the market through a style lens, however, suddenly a much more interesting and useful picture emerges.

It wasn't a great year for all stocks in 1999, just for the glamour growth stocks of the era. While growth-fund managers enjoyed a tail wind, their value counterparts faced a significant head wind in the same market. No wonder so many value managers were tempted to wander over into the growth territory during that period. (And there's nothing wrong with that, as long as it is within the agreed-upon parameters set between the manager and the investor. Tools like Morningstar's style box aren't designed to tell managers where to invest, but simply to illuminate the implications of their choices.)

Conversely in 2001, small-value funds had the tail wind, and growth struggled. The pronounced impact the collapse of big growth stocks had on cap-weighted indexes led commentators to label 2001 a bear-market year. However, the year had pockets of real strength--a fact that only becomes visible if seen through the style lens.

There are years when capitalization, not style, tells the story. In 2003, there was no clear style trend, but a pronounced capitalization trend.

Managers who skewed their portfolios toward large caps likely struggled on a relative basis, while those who bet on small- or micro-cap names enjoyed remarkable success.

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