Our results are good, but we're always aiming to improve.
We track every Fund Analyst Pick and Pan that we've made since we started in 1999. We track a batting average that shows what percentage of funds beat their peer group's average during their tenure on our lists. Here are some of the lessons we've culled from our latest review.
The good news: When we're right, we're really right, and when we're wrong, we're not horrible. The batting average is an aggregated pass/fail grade over time. It doesn't consider the margin of victory or defeat. But the scale of our winning picks' performance is nearly 2.5 times the scale of the losers' underperformance. T. Rowe Price Media & Telecommunications
The opposite is true with our pans. Losers outnumber winners two to one, and the scale of their losses is nearly double the winners' gains. Nearly all of the pans are so far behind their peers that a recovery appears impossible. And the successful pans tend to be funds with narrow purviews, often using leverage, that just happen to have been on the right side of recent market trends. We don't think that they have staying power. A changing market environment could quickly wipe out their gains. For example, Rydex Inverse Dow 2X
Strongest and Weakest Asset Classes
Our picks have done well across all asset groups with 76% succeeding overall, but our U.S. stock picks haven't distinguished themselves lately, with just 56% of them succeeding over the past five years.
There are several reasons. First, a handful of former picks continue to hurt the equity sleeve's results. For example, Fidelity Dividend Growth
A handful of current picks in just a few categories are hurting us now. We're batting less than .500 with our large-blend, large-value, and mid-blend picks. The main culprits are Clipper
One thing is crystal clear: Cheapskates prosper. Picks whose expense ratios are in their category's cheapest quintile did the best--by far--succeeding 83% of the time. Those in the second-cheapest quartile succeeded 60% of the time. We have few picks with above-average expenses, and they did poorly, succeeding just 7% of the time.
Low fees are critical on the bond side. There was a near-perfect correlation between below-average fees and success. That's not surprising. The margin of victory in the bond categories is so small that even a small expense advantage will give the edge to one top manager over another.
The Morningstar Rating for funds does a solid job predicting future success: Picks with the highest star rating did best. We cross-referenced each pick's star rating at the start of the most-recent five-year period with its subsequent success rate. Picks that had 4- and 5-star ratings five years ago consistently outperformed over the next half-decade. They had a 100% success rate in the balanced and muni-bond fund groups, and the numbers were nearly as strong in the taxable-bond and U.S. stock groups. We have few low-rated picks, but most of the handful of U.S stock funds with 2- and 3-star ratings at the beginning of the period underperformed their typical peer over the next five years.
Sense of Style
Indexers had an edge in just one area: bond funds. A passive strategy was a big advantage there, thanks to low costs and the fact that the Barclays Aggregate Index is dominated by government bonds at a time when government bonds have dramatically outperformed. Three bond funds landed among the top-five contributors on the fixed-income side, with several more close behind. It was a mixed bag on the equity side. A couple of index funds excelled, but some of our worst detractors use passive strategies. Vanguard European Stock Index
Family affiliation wasn't an obvious factor in success. Some of our biggest contributors, such as Artisan International and Royce Special Equity
Our picks have been solid, and we've been on target with our must-avoid calls. We are confident that they can help investors build better portfolios. The one obvious recipe for success is to stick with the picks with the highest star ratings and the lowest fees. Low expenses provide an edge everywhere and look like the biggest differentiator among bond funds. After that, it's tough to generalize.
We also learned to pay even more attention to downside risk. Many of the picks that have been hardest hit in the recent bear market sailed through prior downdrafts with flying colors. We expected them to do the same this time around, but they failed. Past performance was definitely not a guarantee of future results. We'll be beefing up our risk-monitoring so that a few misreads don't torpedo results. We'll dig deeper to find hidden risks and put even more scrutiny on picks that are on extended losing streaks. But we won't go overboard. There is still a place for bold mutual funds, and we don't want to try to win the last war by becoming overly conservative ahead of a possible recovery.
The article appeared in the May 2009 issue of Morningstar FundInvestor.
Michael Breen is a senior analyst with Morningstar.