Morningstar Advisor - August/September 2011 - (Page 30)

In Practice Exhibit 3 Finished Where They Started: Percentage of U.S. large-cap funds that began and finished in the same category. Rolling Five-Year Periods 100% 90 80 70 60 05/ 01 01/ 02 09/ 02 05/ 03 01/ 04 09/ 04 05/ 05 01/ 06 09/ 06 05/ 07 01/ 08 09/ 08 05/ 09 01/ 10 09/ 10 05/ 11 Large Blend Large Value Large Growth Embrace Nuance Similarly, our research implies that it’s unwise to evaluate funds’ relative performance using a bright line, such as putting a fund on watch or selling it outright in the event it fails to outperform over a specified time period. While funds must be held accountable through a well-defined sell-discipline, analysis ought to be nuanced enough to acknowledge that they change peer groups with some regularity and adapt to those changes. Rethink Peer Grouping Along those lines, it’s worth considering whether other classification schemes, such as those that adjust to midperiod category changes, could make comparisons more precise. For example, suppose a fund spent half of a period in the large-value category before switching to large blend. Currently, we’d evaluate that fund’s relative performance by comparing its returns with all other funds that finished the period in the large-blend category, irrespective of whether they’d spent the entire period in the category. As an alternative, it could be more meaningful to calculate a percentile ranking that reflected how well the fund had performed against 1) other funds that were also members of the large-value category during the relevant portion of the period and 2) funds that were also members of the largeblend category over the balance of the period. By better acknowledging stylistic differences that can separate even seemingly similar funds, such a system seems likelier to convey how a fund has performed versus its peers. It might also help to stabilize fund rankings which, in turn, could prevent the sort of jarring changes that prompt investors to buy or sell at inopportune times. Reset Expectations Many investors try to pick the funds that they think are likeliest to end up in the category’s top quintile or decile over a particular time period. At first glance, it would appear that the For illustrative purposes only. Categories shown are not unmanaged and not available for direct investment. Past performance is not a guarantee of future results. Exhibit 4 From Whence They Came: Many of today’s mid-blend funds came from other categories. Historical Category Classification of Mid-Blend Funds (as of May 2011) Number of Funds 180 160 140 120 100 80 60 40 20 06/ 06 10/ 06 02/ 07 06/ 07 10/ 07 02/ 08 06/ 08 10/ 08 02/ 09 06/ 09 10/ 09 02/ 10 06/ 10 10/ 10 Mid Blend Mid Value Large Blend Small Blend Large Value Small Value 2001-11 2002-11 2003-11 2004-11 2005-11 2006-11 2010-11 2011-02 2011-05 2001-05 2001-08 2002-02 2002-05 2003-02 2002-08 2003-05 2004-02 2003-08 2004-05 2005-02 2004-08 2005-05 2006-02 2005-08 2006-05 2006-08 2007-05 2007-02 2007-11 2007-08 2008-05 2008-02 2008-11 2008-08 2009-05 2009-02 2009-11 2009-08 2010-05 2010-02 2010-08 Mid Growth Left 02/ 11 For illustrative purposes only. Categories shown are not unmanaged and not available for direct investment. Past performance is not a guarantee of future results. 2011-02 2011-04 2006-06 2006-08 2006-10 2006-12 2007-02 2007-04 2007-06 2007-08 2007-10 2007-12 2008-02 2008-04 2008-06 2008-08 2008-10 2008-12 2009-02 2009-04 2009-06 2009-08 2009-10 2009-12 2010-02 2010-04 2010-06 2010-08 2010-10 2010-12 Implications for Investors While the Morningstar fund categories we examined weren’t a constantly changing lot, they exhibited enough flux to raise questions about how we define investment style, assess consistency, and make judgments about a fund’s relative performance. Disarm the Style Vigilantes Our research suggests that funds change categories more often than is commonly acknowledged. Typecasting funds or strictly cordoning them into a style box seems to fly in the face of this. Yet, many gatekeepers and consultants adhere to a rigid stylebased orthodoxy in screening and monitoring funds. This practice could lead to unsound decisions that reflect less on the merits of the fund than the quirks of the gradingsystem concerned. 30 Morningstar Advisor August/September 2011

Table of Contents for the Digital Edition of Morningstar Advisor - August/September 2011

Morningstar Advisor - August/September 2011
Contents
Contributors
Letter From the Editor
Simplicity and Design Matter
Do You Use ETFs Strategically or Tactically?
The Institutional Way
How to Analyze an ETF
Eyeing ETFs’ Next Chapter
Small-Cap/Large-Cap Flip-Flop?
Four Picks for the Present
Investment Briefs
Morningstar Investment Conference
Pitfalls of Peer Groups
A REIT Recovery, With a Catch
Turning Fund Distribution on Its Head
Here Come ETF Managed Portfolios
Circle These Picks Amid the Crop of New ETFs
ETF Analyst Favorites
Beware, the Accidental Portfolio Manager
It’s the Destination, Not the Vehicle
New Growth, Rooted in Experience
Better Ways to Look at ETFs
How to Better Manage Your Clients’ Future(s)
More Bargain Than Bubble
Cheap, Local, and On a Roll
Mutual Fund Analyst Picks
50 Most Popular ETFs
Undervalued Stocks With Wide Moats
First-Quarter Assets Hit an All-Time High
You Say You Want a Revolution?

Morningstar Advisor - August/September 2011