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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.

American Beacon, Fidelity, Manning & Napier, T. Rowe Price, and Vanguard also had more than one fund in this select group.PAGEBREAK

The downside superstars were CGM Focus CGMFX and Fairholme FAIRX. The former experienced just 27% of its secondary index's downside; the latter was well below half. CGM can short stocks, so it has the potential to greatly reduce bear-market losses. Fairholme, on the other hand, is prone to holding a big cash stake, which also helps.

The group with the strongest upside and downside records also included several great funds hiding in plain sight. The Delafield Fund DEFIX and Homestead Value HOVLX have well under $1 billion in assets, and Polaris Global Value PGVFX inexplicably has less than $200 million.

On the opposite end of the spectrum were Domini Social Equity DSEFX and Janus Worldwide JAWWX, which provided the worst of all worlds. They not only lagged both indexes, but also had smaller gains in up markets and bigger losses in downdrafts.

A group of 14 funds had worse returns than both benchmarks but at least held up better in down periods than their category benchmarks. It's no surprise that such prudent options as Pax World Balanced PAXWX, T. Rowe Price Balanced RPBAX, and Payden Core Bond PYCBX landed in this group.

Some funds weren't nearly as good as they first appeared. Lord Abbett Affiliated LAFFX, Fidelity Value FDVLX, Fidelity Equity Income FEQIX, and Fidelity Equity Income II FEQTX all had asset-class tailwinds that helped them beat their broad-market indexes, but they were subpar against their category benchmark. Each was done in by inferior downside performance. That's particularly disappointing for the equity income funds--defense is supposed to be a key selling point.

Contrasts in Style
The vast majority of funds consisted of winners, and they got the job done in a specific manner. Against the broad market, the results split fairly evenly between funds whose upside capture ratios were so good that they offset poor downside grades, and vice versa. Against the category-based benchmarks, success was more muted on the upside, but there was more success at cutting losses. Just 18% of the funds succeeded by soaring in buoyant markets and taking bigger lumps in losing periods. But 60% outperformed their category benchmarks by coupling great downside chops with good gains in up markets. That was an edge for many of the comparatively prudent growth funds, including American Century Growth TWCGX and Brandywine Blue BLUEX--not surprising in a decade with two bear markets.

A look at the large-blend category proves there's more than one way to get the job done. Take Janus Contrarian JSVAX and Sequoia SEQUX. Contrarian gained a solid 5.2% annually the past 10 years, not far behind Sequoia's 6.4% gain. But Contrarian only made hay while the sun shone, topping the S&P 500 by 43% in up markets but capturing about 20% more of its downside. Meanwhile, Sequoia participated in only 72% of the S&P 500's upside but captured a scant 43% of its downside. The pattern was the same for Neuberger Berman Partners NPRTX and Oak Value OAKVX, where the former was a darling in buoyant markets but took lumps in losing periods, while Oak Value more closely hewed to Sequoia's tack.

What Works Best
There's no one right way to invest--only what works best for your clients. During the past decade, protecting on the downside has been a big edge, as has value investing. But expect things to even out. An extended bull market would upturn the study's results, so fight urges to win the last war--that's a recipe for failure.

You can't control or predict the markets, but you can put a dent in variability by using funds with predictable risk/reward profiles run by managers who stay true to form. A diversified portfolio featuring funds of several stripes is the best way for most to tame the emotional roller coaster of wide market swings.

Michael Breen is an associate director of fund analysis with Morningstar.

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