How Have Our Picks Done Versus Our Pans?

Taking Stock
The good news: When we're right, we're really right, and when we're wrong, we're not horrible. The batting average is an aggregated pass/fail grade over time. It doesn't consider the margin of victory or defeat. But the scale of our winning picks' performance is nearly 2.5 times the scale of the losers' underperformance.  T. Rowe Price Media & Telecommunications is a top dog. It has returned 5 times as much as its typical rival since we made it a pick in early 2007. Other stalwarts include longtime picks  Artisan International ,  Vanguard Wellington , and  American Funds New Perspective . All have posted big gains since we added them, while their peers are deep in the red. These picks have built themselves a big lead that will be tough to lose. Our two poorest-performing picks are specialty funds that lag badly, but nearly all other laggards trail their peers by such a small margin that a month or two of outperformance would vault them back into the winner's circle.

The opposite is true with our pans. Losers outnumber winners two to one, and the scale of their losses is nearly double the winners' gains. Nearly all of the pans are so far behind their peers that a recovery appears impossible. And the successful pans tend to be funds with narrow purviews, often using leverage, that just happen to have been on the right side of recent market trends. We don't think that they have staying power. A changing market environment could quickly wipe out their gains. For example, Rydex Inverse Dow 2X provides 200% exposure in the opposite direction of the Dow Jones Index. It hit a home run in 2008 but has lost more than 25% the past month as the market has rebounded.

Strongest and Weakest Asset Classes
Our picks have done well across all asset groups with 76% succeeding overall, but our U.S. stock picks haven't distinguished themselves lately, with just 56% of them succeeding over the past five years.

 

 

There are several reasons. First, a handful of former picks continue to hurt the equity sleeve's results. For example,  Fidelity Dividend Growth is still a big detractor even though we cut the streaky fund in 2008 after it changed managers. And we recently removed  Vanguard Growth Equity as a pick when it fired longtime manager Turner Investment. Turner's momentum style feasts on buoyant markets but gets crushed in downdrafts, so it has struggled.

A handful of current picks in just a few categories are hurting us now. We're batting less than .500 with our large-blend, large-value, and mid-blend picks. The main culprits are  Clipper ,  Schneider Value ,  Dodge & Cox Stock , and  Weitz Hickory . All four got poleaxed holding financials, and even some homebuilders, early in the current bear market. We underestimated their capacity for near-term losses and are paying the price. They've made up a lot of ground lately and still have great long-term records, but they haven't fully dug themselves out of their holes. We remain confident in all, but they're lagging their peers over the past three years and crimping our success rate.

Low fees are critical on the bond side. There was a near-perfect correlation between below-average fees and success. That's not surprising. The margin of victory in the bond categories is so small that even a small expense advantage will give the edge to one top manager over another.

Seeing Stars
The Morningstar Rating for funds does a solid job predicting future success: Picks with the highest star rating did best. We cross-referenced each pick's star rating at the start of the most-recent five-year period with its subsequent success rate. Picks that had 4- and 5-star ratings five years ago consistently outperformed over the next half-decade. They had a 100% success rate in the balanced and muni-bond fund groups, and the numbers were nearly as strong in the taxable-bond and U.S. stock groups. We have few low-rated picks, but most of the handful of U.S stock funds with 2- and 3-star ratings at the beginning of the period underperformed their typical peer over the next five years.

Sense of Style
Indexers had an edge in just one area: bond funds. A passive strategy was a big advantage there, thanks to low costs and the fact that the Barclays Aggregate Index is dominated by government bonds at a time when government bonds have dramatically outperformed. Three bond funds landed among the top-five contributors on the fixed-income side, with several more close behind. It was a mixed bag on the equity side. A couple of index funds excelled, but some of our worst detractors use passive strategies.  Vanguard European Stock Index hurt us most, as it hasn't kept pace with racier rivals.

Family Ties
Family affiliation wasn't an obvious factor in success. Some of our biggest contributors, such as Artisan International and  Royce Special Equity , were funds from small shops. The big complexes acquitted themselves well despite a few clunkers. Vanguard, Fidelity, and T. Rowe Price, who have the most picks, all showed well, and their success owes in part to low costs. For example, the bulk of Vanguard's successful picks were index funds in the bond group, where a cost advantage was huge.

Take-aways
Our picks have been solid, and we've been on target with our must-avoid calls. We are confident that they can help investors build better portfolios. The one obvious recipe for success is to stick with the picks with the highest star ratings and the lowest fees. Low expenses provide an edge everywhere and look like the biggest differentiator among bond funds. After that, it's tough to generalize.

We also learned to pay even more attention to downside risk. Many of the picks that have been hardest hit in the recent bear market sailed through prior downdrafts with flying colors. We expected them to do the same this time around, but they failed. Past performance was definitely not a guarantee of future results. We'll be beefing up our risk-monitoring so that a few misreads don't torpedo results. We'll dig deeper to find hidden risks and put even more scrutiny on picks that are on extended losing streaks. But we won't go overboard. There is still a place for bold mutual funds, and we don't want to try to win the last war by becoming overly conservative ahead of a possible recovery.

The article appeared in the May 2009 issue of Morningstar FundInvestor.