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Taking a Look at Morningstar's "Analyst Picks"

Morningstar analyst Michael Breen recently wrote an article in which he tried to answer the big question: How hard is it to find funds that beat the market?
The answer is that it's harder than Breen thinks it is. But even more importantly, it's the wrong question.

Breen seems to equate settling for the market return in the form of an index fund to resigning oneself to being average. He notes that a parent would never encourage their child to stop striving for an A when the average student in their class earns a C, and that while the average restaurant in Chicago might be, well, average, it's not "difficult to do a little research and find a good one."

Unfortunately, his examples have nothing to do with investing. Unlike investing, for example, your child's schoolwork is not a zero-sum game, in which one student's A must be offset by another's F. There's no reason that a classroom full of brilliant and motivated students can't all earn A's.

Investing, on the other hand, is a zero-sum game. If my brilliance allows me to beat the market by five percent in a given year, that means there's another investor out there who's lagged the market by that amount.

And unlike the search for a fine meal, the past tells us very little about the future in the investment world. If I choose to dine at a restaurant that's earned the highest Michelin rating, I can be very confident that my meal there will resemble the sorts of meals that earned that high rating.

But if I invest in a fund that's earned the highest Morningstar rating, there is unfortunately no basis for my belief that the fund's future performance (on either an absolute or a relative basis) will have anything to do with the past performance that resulted in that high rating.

As proof of his thesis that selecting superior-performing funds isn't as difficult as many would have you believe, Breen provides a list of criteria that top-performing funds often share. Indeed, his list resembles the traits that I said investors should use to screen actively managed funds. And to verify the validity of this approach, Breen conducts an analysis of Morningstar's "Analyst Picks," which are funds selected by Morningstar analysts as worthy investments.

I confess that I was unimpressed by Breen's findings that more than 70 percent of the Analyst Picks had a record of outperformance. I could easily create a list of "Nathan Hale's Picks" full of nothing but funds that have outperformed in the past. That's easy. What's hard is selecting funds today that will outperform tomorrow.

To test Breen's belief in the utility of Morningstar's Analyst Picks in identifying future winners, I pulled out a list of their picks from ten years ago. They identified 34 non-index funds that fall into their nine equity style boxes (Large-cap Growth, etc.).

I tracked the performance of these funds over the following 9.75 years (through September 2010), comparing each fund's annual return against its appropriate index.

So how did they do? On average, the 33 surviving funds earned a return over the subsequent period that lagged their respective benchmarks by 0.5 percent per year. (I highlighted the word surviving because one of the Analyst Picks -- Van Wagoner Post-Venture -- failed spectacularly and went out of business. If its record were included in the group's results, they would unquestionably be much worse.)

Sixteen of the surviving funds outperformed their benchmarks, and 17 underperformed, a success rate that's nearly identical to the 50/50 odds you would expect purely by chance.

Finally, the winning funds outperformed their benchmarks by an average of 1.7 percent per year. The losers underperformed by 2.6 percent per year. In other words, the upside provided by the winning funds was less than the downside provided by the losers, without even accounting for the performance of the Van Wagoner fund.

This experience gets to the real question investors should ask themselves as they undertake the search for outperformance: Toward what end?

If you're successful, what's the potential benefit? And if you're not successful, what's the cost? It turns out that in wagering on an actively managed fund, you're likely making an asymmetrical bet: the payoff if you win is less than the potential penalty for losing. There isn't a bookmaker in Vegas who would take those odds.

Meanwhile, the market return is there for the taking in the form of an index fund. And despite Breen's belief, accepting the market's return has nothing in common with settling for a C in school, for the lowly "average" return provided by the market over the long-term will inevitably result in long-term returns that are superior to the returns earned by the vast majority of investors, who will, by definition, lag the overall market.

Even better, accepting the market's return removes the very real risk that your fund will underperform over a long period of time.

This isn't meant to denigrate Morningstar's Analysts Picks. And I wouldn't be surprised if one were able to find a similar period in which their selections had outperformed. But in the end, I have little doubt that in the aggregate, they're average.

The problem is that investing is a tough business. And no matter how many common-sense screens you run, or how many analysts you have poring over historical data, you're still making a bet with the odds firmly stacked against you.

If you find that appealing, good luck in your search. Just make sure that you go in with your eyes wide open.

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