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Benchmarks? What Benchmarks?

Try this screen for core funds that take the road less travelled.

Karin Anderson, 03/14/2011

This article first appeared in the February/March 2011 issue of Morningstar Advisor magazine. Get your free subscription today!

Actively managed funds that don't move in lockstep with the overall market may be appropriate portfolio anchors for certain clients, while others may be more comfortable using them to complement core index offerings. These funds tend to be run by managers who don't let benchmarks guide their stock-picking or sector-weighting decisions. You can use this straightforward screen in either Morningstar Advisor Workstation or Morningstar Principia to turn up intriguing large-cap funds which have delivered compelling returns without following an index.

Special Criteria = Distinct Portfolios Only
And ( Morningstar category = Large Value
Or Morningstar category = Large Blend
Or Morningstar category = Large Growth
Or Morningstar category = Mid Value
Or Morningstar category = Mid Blend
Or Morningstar category = Mid Growth )
And Purchase Constraints = Closed-New Investment
And Min Initial Purchase < 25,000
And Analysis not = NA

To set up the screen, narrow the field to domestic large- and mid-cap funds that are open to new investments of $25,000 or less and followed by Morningstar Analysts.

And R2 3 Yr < 85

Next, set the three-year R-squared measure, which represents the percentage of a fund's performance that can be explained by movements in a benchmark index, to 85 or less. (The median R-squared for all U.S. large-cap funds clocked in at 94 for that period.) In the case of all U.S. equity funds, the S&P 500 is used as the standard index, and an R-squared of 100 indicates that the fund's performance moved in tandem with that benchmark.

And % Rank Cat 5 Yr < 33
And ManagerTenure (Longest) > 5
And Audited expense ratio < 1.25

Lastly, narrow the search to funds with top third five-year rankings and manager tenures of at least five years. The median expense ratio for broker-sold large-caps is 1.25% annually, which is the cut-off here.

Side note: This screen can be run for large-cap international equity funds, in which case it would compare those funds with the MSCI- EAFE Index.

Here are some of the resulting funds:

CGM Mutual LOMMX
Of the funds that made it past this screen, CGM Mutual's performance was most distinctive relative to the S&P 500.

Longtime manager Ken Heebner's is willing to make big investments in individual positions, such as his 10% stake in Ford F, as well as sectors (the fund's 48% stake in consumer goods was over four times the S&P 500's). Heebner typically moves in and out of sectors quickly while often holding a decent chunk of assets in treasuries and corporate bonds. (Its stock/bond ratio was recently around 75/25, but its average bond allocation in the past three years wasn't high enough to move the fund to the aggressive allocation category.) So, it's not surprising to see this large-growth fund's R-squared measure was a mere 65. The manager's fast-trading style can lead to an unpredictable portfolio and lumpy performance, but long-term it has delivered the goods.

He has executed this distinctive approach effectively over time. Over the past decade the fund's 5.7% annual return is topped only by CGM Focus' 17.2% gain in the large-growth category. Volatility, though, has been on par with its typical peer's over the past five- and 10-year periods.PAGEBREAK

PRIMECAP Odyssey Aggressive Growth POAGX
This fund invests across the market-cap spectrum and falls into the mid-cap growth category. Four managers run separate sleeves of this offering, but they're all generally on the look out for firms that have grown quickly but are temporarily out of favor.

They often buy small-cap firms and hang on until they grow into mid-cap territory, and |large stakes in health-care and tech- nology stocks have cropped up over the years. And at last count, about two thirds of the fund's holdings didn't reside in the index. All these factors have kept its three-year R-squared number at 84. The fund's experienced managers and their deft stock- picking have made this a tough one to beat.

Fairholme FAIRX
Going his own way is the foundation for manager Bruce Berkowitz's success here. In addition to a large stake in mid-cap stocks, his willingness to buy high-yielding senior debt and real estate as well as hold large cash stakes has made this fund stand out from the crowd. Indeed, this fund had a three-year R-squared of 81. Thanks to strong stock selection, this large blend offering has produced returns that have handily, and consistently, outpaced the index and the competition.

Berkowitz knows that to beat the pack you have to break from it. In a flashback to the fund's early years, Berkowitz again has nearly three fourths of its equity assets in financial-services stocks-four times the category average. In 2010, he loaded up on debt and equity from a number of firms that were hit hardest in 2008's crisis, including American International Group AIG and Citigroup C. Berkowitz said the firms were survivors that were simply too cheap, and his thesis is starting to be confirmed.

Sequoia SEQUX
This fund holds between 10 and 25 stocks owns non-index stocks, such as Valeant Pharmaceuticals International VRX and Indexx Laboratories IDXX, and often has a double- digit cash stake. So its three-year R-squared clocked in at 80. Managers Bob Goldfarb and David Poppe otherwise take a straightforward approach to stock selection that has been highly successful over the long term. They like simple businesses which boast some sort of enduring advantage, and they take the managers' records seriously.

A disciplined emphasis on quality firms gives the fund a predictable, attractive risk/reward profile. It has experienced about 80% of the S&P 500's upside but only 50% of its downside the past decade. A manageable asset base and reasonable fees add to its appeal.

Yacktman YACKX
Veteran managers Donald Yacktman and Stephen Yacktman tend to favor consumer- and service-oriented stocks that have strong cash flows, little debt, and discounted stock prices. True, top holdings Coca-Cola KO and Procter & Gamble PG as also are in the S&P 500 Index, but smaller-cap companies like C.R. Bard BCR and Liberty Media Corp LINTA, which aren't in the index, also hold prominent spots. And management also bets big on individual stocks, as its recent 9% stake in News Corporation NWSA attests, giving this portfolio its distinct look and a three-year R-squared of 84. Though management's contrarian bets and long-term outlook can cause this fund to lag for extended periods of time, it should continue to be a long-term winner.

Karin Anderson is a mutual fund analyst with Morningstar.

Karin Anderson is a senior mutual fund analyst with Morningstar.

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