Looking Closer at Morningstar Peer Groups for Fund Analysis

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Looking Closer at Morningstar Peer Groups for Fund Analysis by Royce Funds

Director of Risk Management Gunjan Banati sits down with Co-Chief Investment Officer Francis Gannon to discuss the results of her Morningstar peer group research and suggests ways in which investors can compare funds within peer groups more effectively.

See Gunjan Banati video on Morningstar peer groups here.

Francis Gannon: So tell us about the most recent Royce research article.

Gunjan Banati: Our most recent article is based on peer groups, specifically how the Morningstar peer groups have changed over time.

We get a number of questions through due diligence about which peer groups should our different Royce Funds be compared to and why, sometimes, when we say that it’s a certain kind of small-cap fund that it doesn’t look the same in the Morningstar style box, or the Morningstar category, and also the Morningstar peer groups.

Francis: So Morningstar does have peer groups, the categories, and styles. What’s the difference between them all?

Gunjan: That’s a great question. So the style box is the most common graphic that you see that Morningstar puts up, and what that is is that’s a point-in-time snapshot of where your portfolio’s holdings are aggregating as a centroid onto that particular grid. And when you look at a category, what that is is that’s a three-year look-back at where all those style boxes have been, so they aggregate those then to come up with your category, and your category is what determines your peer group. So your peer group and category will always be the same, but your style box may be different.

Francis: Well, how can there be a disconnect sometimes between where advisors think our Funds should be and where Morningstar places them?

Gunjan: Well, there’s a number of different reasons why there might be a disconnect. Morningstar’s process of putting a fund into a category or style box is completely formulaic. It’s based on your holdings.

Francis: It’s a snapshot.

Gunjan: Correct. They don’t actually ask the portfolio manager, “Where do you think you should reside?” This is based on the holdings. So as a result of that, where you think you should be might be different based on where your portfolio currently is in terms of the evolution of the market cycle, an evolution of an investment thesis, and, also, it’s a comparative computation, so it could also be based on the fact that everybody is doing something else differently.

Francis: So you did a deep dive into the small-cap category. How did you compile that data?

Gunjan: What we did to compile this data is we tried to actually recreate what a Morningstar category looked like 10 years ago. So we were looking at just the small-cap categories for this exercise, and so we looked at all funds that were in the small-cap Blend, or Value, or Growth at year end 10 years ago, adding back in all the liquidated funds and all the merged funds just to create a picture of what that would have been, and we did that for 10 years ago, for five years ago, and for three years ago, then compared it to today.

Francis: And what stood out in the results?

Gunjan: Our results were actually really interesting. We were surprised to see the degree of flux that takes place in Morningstar peer groups. For example, in the small-cap Value category that we looked at, we found that only 33% of funds stayed in the same category over a 10-year period of time.

Francis: Now does that change over shorter periods, three and five years?

Gunjan: So we looked at shorter time periods as well. For example, again, in small-cap Value, we found that over a five-year time frame 48% of funds stayed in the same category and the rest of them had actually moved or had been liquidated out of the category, and over a three-year period, across all three categories, we saw only about 75% of funds stayed in the same place. So that means one in four funds actually moved out of that category over a three-year period.

Francis: So given the amount of flux you saw in your data, how are investment advisors effectively able to compare funds within peer groups?

Gunjan: So one of the ways we’d suggest is instead of looking at just the Morningstar-defined categories of Blend, and Value, and Growth, to create larger categories, and that’s something we do here at Royce. We create a much broader category and compare our Funds to, say, all small-cap funds.

Francis: So could advisors create custom groups as well?

Gunjan: Absolutely. That’s a great example. You can create custom groups in a number of different ways. You can use a combination of holdings-based, style-based analysis. I would suggest asking the portfolio manager where do they think they should be in a peer group, and using that to create custom peer groups.

Francis: Can you give us an example of a custom peer group?

Gunjan: Sure. For example, if you were trying to evaluate a dividend-oriented large-cap strategy, you could compare it to the Morningstar category it’s in, which would probably most likely be large-cap Value, and you’d be subjected to some of the flux issues that we see with creating, with comparing, funds within a category. You could create a custom category of all dividend-oriented large-cap funds and use that instead, and I think you’d find the results would be a lot more accurate.

Read the research article: How Morningstar Category Flux Impacts Peer Group Analysis

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