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How To Pick Outperforming Funds

There is one actively managed fund group that has not disappointed: Morningstar’s fund managers of the year.

Plenty of academics sneer at actively managed mutual funds. Investors should shun active funds because it’s difficult—if not impossible—to predict future winners, they say. But there is an actively managed fund group that has not disappointed: Morningstar’s fund managers of the year. Most managers who win the award go on to beat their categories.

Morningstar presents the annual awards with much fanfare, and many winners run ads announcing their victories. To find out whether the prizes are deserved, we examined all the funds that had won during the ten years beginning in 1995. Morningstar grants awards for three categories: domestic stock, international stock, and bonds, so there were a total of 30 winners in our sample. Of those, we found that 22 had gone on to outperform their categories during the three years following their awards.

In fact, most of the award recipients outpaced their categories by comfortable margins, too. Notable performers included Davis New York Venture (NYVTX), which won in 1996 and went on to beat its large blend peers by 3 percentage points over the next three years. Other funds that surpassed peers by more than 3 percentage points were Fidelity Low-Price Stock (FLPSX), which won in 2002, and Vanguard Primecap (VPMCX), the manager of the year in 2003.

Of the eight funds that lagged their peers, very few blew up. Most of them turned in respectable showings. Years after winning the award, nearly all the Morningstar champions remain attractive choices. For example, FPA New Income (FPNIX) won in 2001. For the next three years, it returned 4.22 percent annually, lagging the average intermediate-term bond fund by 44 basis points. But FPA remains a compelling low-risk performer that has navigated the difficult markets of recent years while avoiding losses.

So should you buy the Morningstar winners? Perhaps. But whether you invest in the prize recipients, it is worth considering the system that goes into selecting the outstanding funds. As the data indicate, Morningstar seems to have developed a no-nonsense selection approach that actually works.
To begin with, Morningstar does not just take funds with the best raw performance numbers. Instead, the analysts look for funds that “have made a lot of money for a lot of investors over a long period of time.”

That may sound “squishy,” but Morningstar then delves a little deeper. The fund research firm locates the best workhorse funds by looking at investor returns, a measure of the gains achieved by each dollar in a fund. To appreciate why investor returns may be more significant than raw returns, consider the results of two strong performers, Fidelity Contrafund (FCNTX), a large growth fund that won the Morningstar title in 2007, and CGM Focus (CGMFX), which has never been awarded the prize, even though it is one of the top-performing funds of all time. During the five years ending in October, CGM returned 7.83 percent annually, compared to 4.65 percent for the Contrafund.

While the raw returns suggest that CGM is ahead, the investor returns tell a different story. The average dollar invested in CGM lost 16.09 percent. This occurred because the fund is very aggressive, scoring big gains during hot periods and suffering sizable losses when the manager’s hand turns cold. Foolish investors have poured into the fund just when it was peaking—in time to record big losses. In contrast, Contrafund delivers steady results to investors who stay for the long term. Under the Morningstar system, reliable winners, such as the Contrafund, can win the prize, while erratic performers like CGM are left out in the cold.

Besides searching for strong investor returns, Morningstar looks for managers who invest in their own funds. Morningstar research director Russel Kinnel has been tracking manager investments for the past couple of years. The data are not conclusive yet, but he is convinced that the best skippers eat their own cooking. Kinnel says that managers tend to invest in their own funds when the fees are low. When fees are high, managers tend to avoid betting on themselves. Indeed, each of the managers of the winning funds has invested at least $1 million in the fund. In contrast, most also-ran managers don’t invest anything in their own funds. Apparently plenty of fund managers may lack skill, but they are smart enough to avoid funds with shaky records and high fees.

As an additional check, Morningstar only takes funds that have applied the same winning investment strategies through up markets and down. Kinnel believes that when a manager has long succeeded by following a consistent approach, he can continue winning for years to come.

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