A Solid Batting Average for Our Fund Analyst Picks
Our best and worst picks in 2006.
It's time once more for a quarterly update on the performance of our Fund Analyst Picks.
First, a preamble on what the picks are and how we judge their performance. The Fund Analyst Picks are a buy list representing our view on funds with the best prospects for strong long-term performance. Funds are intended as long-term investments, so we aren't trying to pick hot funds for the next quarter but instead ones that can get you to your goals. Our picks are based on key fundamentals with the greatest predictive value. We look for low-cost funds run by skilled managers with sound strategies. They should also come from companies that rate highly as good stewards of fundholder money. To get our arms around all of these factors, we devote a lot of time to interviewing fund managers and visiting fund companies.
To measure our success I use a weighted batting average that measures whether funds outperformed their peer groups when they were picks and then weights that success based on how long they were picks. (By that I mean that a fund that has been a pick for five years would receive more weight in the batting average than one that has been on our picks list for only a year.) It sounds complex, but it's the best way of measuring success given that we make changes whenever needed, thus producing a slew of different time periods to measure. It also helps overcome the challenge of finding a good index for every single category.
Steady As She Goes
Adding in performance for the fourth quarter 2006, our batting averages are little changed. For the trailing three years our picks outperformed 69% of the time and for the trailing five years they outperformed 64% of the time. That compares with 69% and 65%, respectively, for the trailing periods ending third quarter 2006.
Another way of looking at our picks performance is to compare them with an index. Over the trailing five years our domestic-equity picks returned an annualized 9.32% compared with 7.65% for the Dow Jones Wilshire 5000 and 6.19% for the S&P 500.
Best- and Worst-Performing Picks for 2006
As I said above, our picks are designed for the long term, but it's still interesting to look back at some of our best and worst picks from 2006. All of the funds I'll mention here were picks for all of 2006 and remain picks today, so you can safely assume we still have faith whether they are red-hot or supercold.
In terms of relative performance, that is, ranking versus peer group, our three top-performing picks were American Funds Income Fund of America (AMECX), T. Rowe Price Latin America (PRLAX), and Loomis Sayles Bond (LSBRX). The first two ranked in the top percentile of their categories while Loomis Sayles Bond was top 6%. Income Fund of America's strong 2006 was driven by its big weighting in equities and its bias toward the value side of the Morningstar Style Box. However, we like it for its excellent management and low costs. T. Rowe Price Latin America had good stock selection and a low cash stake, and in a small peer group it doesn't take much to end up at one extreme or the other. Loomis Sayles Bond managers Dan Fuss and Kathleen Gaffney nearly won our Manager of the Year award thanks to brilliant calls on some emerging-markets debt among other things.
In absolute terms, the best returning picks were the aforementioned T. Rowe Price Latin America, which gained 51.24%, and two real-estate picks, Morgan Stanley Institutional U.S. Real Estate (MSUSX), up 38.85%, and JP Morgan U.S. Real Estate (SUSIX), up 36.21%. We liked the two real estate funds' tremendous depth and skill, although real estate has had such a strong rally I wouldn't rush into either one today. In fact, you can't rush into the Morgan Stanley fund because it closed on Jan. 12.
On the downside, our worst relative performers were FPA Capital (FPPTX) and FPA Paramount (FPRAX), which landed in the bottom 3% of their categories, and Diamond Hill Small Cap (DHSCX), which was bottom 4%. The FPA funds are low-turnover iconoclasts, so it's not uncommon to see them in the top or bottom decile's of their categories. FPA Capital was hurt by its energy stake, a big defensive cash position, and some individual blowups. Bob Rodriguez is focused on protecting against the downside as much as participating in rallies, so a down year in a strong market year is not a shock. The fund's long-term record is also fabulous: Over the trailing 15 years the fund has returned 866% compared with 621% for the average small-value fund. At FPA Paramount the problems were its growth bias and some individual challenges at its focused 35-stock portfolio. Again, I'm not worried, despite the rough year, because you have good managers and a sound, low-turnover strategy. The story at Diamond Hill Small Cap is sort of similar to FPA Capital in that energy stocks and a cash stake held it back. I'm confident Ric Dillon and Tom Schindler will rebound because of their solid long-term track record and healthy corporate culture.
In absolute terms our weakest picks were Vanguard Inflation-Protected Securities (VIPSX) (0.43%), Harbor Capital Appreciation (HACAX) (2.33%), and PIMCO Foreign Bond (U.S. Dollar-Hedged) (PFODX) (2.48%). However, all three actually performed pretty well relative to their peers despite weakness in their asset class. Weakness in Treasury Inflation-Protected Securities, large growth, and the dollar, respectively, hurt the funds. When I see a good fund held back by asset-class weakness I tend to want to buy more so that I'll be there for the rebound. Harbor Capital Appreciation actually beat most large-growth funds, and the other two will rebound when TIPS and the dollar do. PIMCO Foreign Bond (U.S. Dollar-Hedged) is one of the few foreign bond funds not to hedge and, thus, one of the few not to participate in the dollar's fall. PIMCO actually offers its strategy in hedged and unhedged formats.
Our picks are designed to help you get right to the best of the best. You'll find great stewards who are skilled investors. To get the best results, though, you need patience. Even our five-year results are at the short end of the time frame for which you should hold your funds. If you stick with these funds your chances for success are good--but there are no guarantees. Many of our best recommendations suffered through stretches of underperformance. Jean-Marie Eveillard's First Eagle Overseas (SGOVX), for example, saw a number of investors bail out in the late 1990s because his caution on valuations left him far removed from the dot-com bubble. However, that liability soon turned to a virtue as he protected shareholders' money quite well in the ensuing monsoon.
In other words, we can point you to the right funds but using them wisely in a diversified portfolio is up to you.
Russel Kinnel has a position in the following securities mentioned above: HACAX, LSBRX. Find out about Morningstar’s editorial policies.