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Fund Spy

A Great Batting Average for Our Fund Analyst Picks

We've built a strong record of picking mutual fund winners.

The following is an excerpt from the September issue ofMorningstar FundInvestor, Morningstar's monthly newsletter with research and recommendations for the serious investor. In the article I provide more details on our best- and worst-performing Analyst Picks and how our picks fared by category.

Our goal in selecting Fund Analyst Picks is to find funds with good prospects for superior long-term returns without undue risk. Today, I'll show you how we're doing.

First, a quick recap of what we look for in picks and how our process has evolved. We aim to pick funds that will provide better risk-adjusted returns than other funds in a given category.

To help unearth winners, our analysts focus on the areas proved to be linked to superior risk-adjusted returns: costs, stewardship, management, strategy, and long-term performance.

In 2002, we complemented our picks with the introduction of Fund Analyst Pans. To select pans, we search for the inverse of what we look for in our picks.

In 2003, we formalized our selection process by creating a vetting committee to review the picks. Analysts submit their nominations and explain their rationale. The current committee consists of director of fund analysis Christine Benz, associate director of fund analysis Scott Berry, director of securities analysis Haywood Kelly, and me. In 2005, we began including closed funds among our picks because our subscribers wanted more guidance on whether we still liked the picks after they closed. (Morningstar.com Premium Members can see our current list of picks by  clicking here.)

Measuring Success
The best measure of our success in recommending winning funds is a weighted batting average that shows how often our picks outperformed their category peers. To arrive at the batting average, I weighted the data based on how long the fund was an Analyst Pick. That means that a fund that was a pick for just six months counts only one fourth as much as one that was a pick for two years.

Because providing you with picks that offer good downside protection is a key goal in our process, I also looked at what percentage of our picks landed in the bottom quartile of their respective categories. If we're successful at picking funds with good risk/reward profiles, then our picks should be under-represented in the bottom quartile of their categories. I applied the same measure to our pans, only the batting average tells you what percentage of pans underperformed their category peers. And as with the picks, I also looked at the number of pans that finished in the bottom quartile of their categories.

I also looked at how our picks fared as judged by the Morningstar Rating. Because the picks are aimed at finding superior risk-adjusted returns, it's worth seeing how they score on our best-known measure of risk-adjusted returns.

Strong Performance from Our Picks
The results indicate our Fund Analyst Picks are a pretty good bet to outperform. More than two thirds of our picks, 67% to be precise, outperformed their peer groups over the trailing three- and five-year periods ending June 30, 2006.

Our batting average for Fund Analyst Pans was pretty good, too. Introduced in 2002, our pans have produced a three-year batting average of 56%--meaning that 56% of the time, our pans underperformed their category peers. The distributions by top and bottom quartile indicated that our pans were in fact quite risky and our picks were not. Only 12% of our picks were in the bottom quartile of their categories for the trailing five years, and 14% were in the bottom quartile for the trailing three years. Even better, 36% of our picks over the past five years were top-quartile and a whopping 41% were top-quartile over the past three years.

Meanwhile, the pans were often cellar dwellers. Over the past five years, 38% were in the bottom quartile, while 32% landed in their category's bottom quartile over the past three years.

That tells me that we're identifying dangerous funds that don't justify the risks.

Star Gazing
To get a sense of how we did on a risk-adjusted basis, I looked at the Morningstar Ratings that our picks from three and five years ago earned over the ensuing three- or five-year periods.

The results were encouraging. For the trailing three years, our picks averaged a rating of 3.4 stars compared with 2.5 stars for our pans. Our picks from five years ago also earned 3.4 stars over the ensuing five years.

How'd We Do against the S&P 500?
Over the trailing five years our domestic-equity picks have nearly tripled those of the S&P 500. Specifically, they've returned 34.6% (not annualized) versus 13.5% for the index.

That's a great number, but the S&P 500 was an easy target the past five years. Many of our picks were in small- and mid-cap categories, where beating the S&P 500 was a piece of cake in recent years. Anyone who tells you their performance against the index without mentioning that it will be far more difficult to repeat that success over the next five years is snowing you. I'd imagine the index will put up a better fight over the next five years, but I'm confident we have a good shot at keeping our great batting average going.

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