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Find the Right Fit

Tailoring a portfolio to a client's risk/reward profile is a matter of capturing how funds perform in up and down markets.

Michael Breen, 10/04/2010

There are many routes to the same investing end. All contain ups and downs. Some have higher highs and lower lows; others provide a smoother journey. But a path can't take you where you want to go if you won't stay on it. That's why it's critical to understand not only what a mutual fund's long-term returns are, but also how they were generated. Armed with this knowledge, investors can align their risk/reward profiles with like-minded funds, increasing the chances that they will stay the course en route to their long-term goals.

We dissected the records of some top funds to see how they performed overall and in up and down market stretches. Some patterns emerged that should help you better tailor your clients' fund selection to fit their portfolios.

The Study
We took the funds in the Morningstar 500-- a list compiled by the editors of Morningstar FundInvestor of the industry's best and most notable funds--and looked at their returns and upside and downside capture ratios going back 10 years. Funds that didn't have 10 years of data were excluded because their records didn't reflect a full market cycle. The capture ratios are helpful because they have a directional component. The upside capture ratio measures a fund's performance relative to the up months of a specific benchmark. The index's baseline score is 100. Funds scoring more than 100 performed better in up periods than the index. The inverse is true for the downside capture ratio.

 We ran the ratios for the funds against their primary and secondary indexes. The primary index represents the broad asset class each mutual fund is in; the secondary index is the specific index for a mutual fund's category and investment style. So, a fund in the health-care category, such as Vanguard Health Care VGHCX, was checked against the S&P 500 Index and the Dow Jones US Heath Care Index.

(View the related graphic here.)

What We Found
First, the Morningstar 500 funds are good. More than 70% of them have topped their primary and secondary indexes over the past decade. Second, funds landed in one of several distinct groups based on how they behaved in up and down markets. (See all of the funds' upside and downside capture ratios at http://morningstaradvisor.com/magazine/whitepaper.asp.)

There were 39 funds that did it all. They not only had better returns than either index, but also consistently outperformed both in up and down periods--no mean feat. The typical fund in this group delivered 20% more upside than its primary index, while suffering only 80% of its downside. The numbers were nearly as good against the category indexes. There were 27 domestic- equity funds, 11 international-stock funds, and one taxable-bond fund in this group.

Family bragging rights go to Oakmark. All five of its funds in the Morningstar 500-- Oakmark OAKMX, Select OAKLX, International OAKIX, International Small Cap OAKEX, and Global OAKGX--delivered the ultimate combination. Oakmark Global delivered the best combination in the entire study, generating 33% more upside than its category index, while suffering just 78% of its downside.

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