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Buy Stock-Pickers, Avoid Sector-Pickers

Separating skill from luck with manager attribution.

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This article was published in the June 2014 issue of Morningstar FundInvestor. Download a complimentary copy of FundInvestor here.

Morningstar analysts often turn to attribution results when digging into a manager's performance. The analysis typically compares a strategy's returns with an index, dividing results between the portion of outperformance attributable to a manager's sector-allocation decisions from the portion that comes from stock-picking results. While the former can often have a big effect on returns--avoiding financials stocks in 2008 has become a go-to example of this--there's much academic and industry research that suggests it is very difficult to consistently make winning market-timing calls.

Morningstar's collective decades of experience analyzing performance suggest that a manager's stock-picking skills tend to have a degree of stability and persistence, though, and we wondered if there was a way to apply the essentially ex-post examination of a manager's attribution results into an ex-ante method of finding future outperformers. Our research is still in its early stages, but the results so far have been promising.

To look into the question, we expanded our analysis of attribution results from its usual manager-by-manager examination into a wider one that compared each fund's attribution results with its peers'. We limited the analysis to the 10 years between April 1, 2004, and March 31, 2014, and looked only at the small-cap value universe. Smaller-cap stocks have generally outpaced their larger-cap counterparts over the past decade, while value- and growth-style small-cap funds have both roughly evenly outpaced those in the blend bucket. Choosing the small-value corner of the Morningstar Style Box, then, helped to prevent results from being skewed by managers' "cheating" via market-cap or investment-style deviations. We also made sure to include all distinct funds that existed throughout the 10-year period, as survivorship bias would otherwise likely positively skew the results.

We then took three-year rolling results and essentially tried to answer this question: If we were to pick 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 would be the chance that those funds would outpace the Russell 2000 Value Index three years later? Figure 1 displays the average success rates of all of those rolling three-year results. 

Source: Morningstar Analysts.

Funds ranking in the top half of the small-value peer group based on the past three years of returns, on average, had a 50% chance of outperforming the index three years later; so at least in this case, past returns provided little to no help in picking funds that would do well in the future. Choosing funds with the strongest past sector-allocation effects seemed to actually provide negative information: Those with the strongest showing on that front, on average, ended up outpacing the index less than half the time three years hence. This goes back to the point about how difficult it is to make good sector bets. It also speaks to the fact that sectors rotate in and out of favor, so a fund that favors a couple of sectors will naturally have ups and downs that likely even out over time.

Picking funds based on stock-picking skill, however, appeared to hold some promise. On average, managers that ranked in the top half of the small-value Morningstar Category based on three-year rolling stock-picking attribution went on to beat the benchmark three years later 55% of the time.

The opposing results suggested by sector allocation and stock selection fell right in line with our thesis on the difficulty of market-timing and the relative stability of stock-picking. We tried to combine the two ideas by next asking: What if we had picked the managers who ranked in the top half of the group by stock-picking but the bottom half by sector allocation? Doing so would eliminate managers who have received a boost from sector-allocation decisions--a source of excess return that has tended to be hard to repeat. Instead, it would isolate those managers and funds that have historically generated their results via stock-picking alone. Using those criteria, the results jumped to a 66% success rate.

Figure 2 presents another dimension of the results by showing the average excess returns that each selected group delivered in the subsequent three-year periods. Funds with peer-beating returns over the past three years, for example, outpaced the index net-of-fees by an average of 50 basis points three years later. (The positive results are similar to the small-value category's slight topping of the index over the past decade). Picking funds based on allocation or stock-picking rankings resulted in somewhat worse or better outcomes, respectively, but picking the funds that relied primarily on stock-picking (funds that ranked in the top half of the group by stock-picking results but the bottom half by sector-allocation decisions) delivered a respectable average annualized excess return of 119 basis points.

Source: Morningstar Analysts.

Screening the Morningstar 500
Within the M500, five out of the nine actively managed small-value funds fell into the group that passed the top-half stock-selection/bottom-half sector-allocation screen, and we present them in Figure 3.

Source: Morningstar Analysts.

Of the five funds, Chuck Myers of  Fidelity Small Cap Value (FCPVX) (which is closed to new investors) tends to keep his sector weightings close to his benchmark's, so by default, his source of added-value has had to come primarily from stock-picking. The managers and teams at  Diamond Hill Small Cap (DHSCX),  Perkins Small Cap Value (JSCVX) (closed),  AMG Managers Skyline Special Equities (SKSEX), and  Third Avenue Small Cap Value (TASCX), in contrast, frequently deviate from the Russell index's sector weightings; all of them more or less do so based on where the most attractive areas of the market take their portfolios.

Finding the Stock-Pickers
If sector-allocation decisions tend to randomly affect results (and, overall, even detract from returns), then separating out the managers who have benefited from those decisions essentially screens out managers who have had luck on their side. It's one way to identify managers with strong returns who have gotten there with a preponderance of luck from those who have true, repeatable skill--the Warren Buffetts. That's not to say that luck can't benefit skillful managers as well, so this screen should be considered as only one input among many when selecting managers. But whether luck is fleeting or not, it's certainly hard to predict, which makes focusing on a stock-picking a promising alternative.

Janet Yang Rohr, CFA does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.