(PUB) Investing 2015

About a year ago, we introduced

Morningstar

FundInvestor

readers to the initial findings from

Morningstar’s research on using peer attribution

to screen and select funds. Starting with the small-

cap value universe, we took a look at if strong

sector-rotation or stock-selection skills in the past

led to better performance in the future.

The results fell in line with expectations: Morningstar

analysts have anecdotally observed that stock-selec-

tion skill tends to be more stable than sector-rotating

dexterity, and peer-attribution data supported

the hypothesis. While the latter can markedly affect

returns in any given period, academic and industry

research has shown that it’s difficult to consistently

make additive market-timing calls. Picking managers

based on their past stock-picking attribution results

led to higher returns and better success rates than

picking them based on their sector-attribution rankings.

We’ve since expanded the research into the large-

growth stock space, a category that’s had a strong run

in the past

years. Using the same methodology

that was used for the small-value findings, we looked

at all distinct large-growth funds that existed in the

years from July

2005

, to June

2015

. We then

used three-year rolling results to answer the ques-

tion: If we picked funds that ranked in the top half of

the group based on the past three years of either

returns, allocation effects, or stock-picking results, what

is the chance that those funds would outperform the

Russell

1000

Growth Index three years later? Exhibit

shows the average success rates of those rolling

three-year results.

The numbers don’t look impressive upon first glance,

but they require some perspective. The Russell

1000

Growth Index has been one of the toughest indexes to

beat of late. During the past

years, using three-

year returns that roll forward every three months, the

large-growth category average has never topped the

index. On average, only

23%

of all large-growth funds

outpaced the index over those rolling three years.

In that context, the success rates in Exhibit

look

somewhat less dire for active managers, which are by

and large the majority of constituents within the

large-growth group. Funds that ranked in the catego-

ry’s top half based on the past three years of returns,

on average, had a

25%

chance of outperforming the

index three years later. That’s slightly better than

the

23%

chance of picking a fund at random. Picking

funds with the best past sector-allocation effects

produced success rates similar to random chance,

adding to the evidence of the difficulty of making

good sector bets. While some funds that tend to favor

certain sectors may see strong sector results at

times, those gains often get wiped out in other periods,

commensurate with how certain sectors come into

and out of favor over time. Meanwhile, funds with

strong stock-picking results had a better chance—at

26%

—of coming out ahead of the index.

If sector rotation doesn’t help but stock selection does,

we tried to combine the two concepts by asking:

What would have happened if we picked managers

that ranked in the top half of their peers by stock-

picking but in the bottom half by sector allocation?

This scenario excludes funds receiving boosts from

seemingly unsustainable strong sector decisions and

instead homes in on those that have had to rely

primarily on stock-picking. Under this scenario, the

success rate increases to

28%

Buy Stock-Pickers, Avoid

Sector-Rotators, Part 2

Morningstar Research

Janet Yang

Data from 07/2005–06/2015. Average percentage of funds that outpaced

the Russell 1000 Growth Index over rolling three-year periods.

Exhibit 1

Success Rates for Lg-Growth Funds Vs. Russell 1000 Growth Idx

Return

Sector

Allocation

Stock

Selection

Sector &

Stock

All