The numbers on the graph correspond to the following excerpts from previous PRI reports published in P&I. A complete record of all 40 reports is available at the P&I website (www.pionline.com) or at www.sortino.com.
1. Third quarter 1995. In this first analysis, PRI technology favored high-tech funds, with the three highest-rated funds being Putnam New Opportunity, T. Rowe Price Science & Technology, and T. Rowe Price New Horizons.
2. Second quarter 1998. The first time PRI warned that high-tech funds were very risky. PRI technology ranked American Century Income and Growth, Vanguard Institutional Index and Vanguard Growth & Income as the highest. This caused the universe to underperform the S&P 500 for the next two years but substantially reduced the downside risk.
3. Fourth quarter 2000. The PRI funds were up an average of 13% in the first decline and up 0.4% in the second decline. The Nasdaq composite was down 38%.
4. Second quarter 2002. A bit too soon, growth funds once again topped the PRI list: T. Rowe Price Growth Stock, Dodge & Cox Stock, Neuberger Berman Genesis and T. Rowe Price Small Cap Stock.
5 Third quarter 2003. I wrote: "The most interesting thing about this quarter's rankings is the low upside potential of the small cap growth equity funds. All of them have more downside risk than upside potential." That was the first warning for this market recovery.
6. Fourth quarter 2004. This year we began ranking all of the funds in the Morningstar database, and we used the Surz indexes for all nine styles. This combination produced an outstanding result: 81% of the PRI funds beat the S&P 500 by at least 150 basis points for the year 2004.
These results are not due to any market-timing skill. They are due to the careful application of quantitative methods developed by Peter Fishburn at the University of Pennsylvania, Bradley Efron and Bill Sharpe at Stanford University, and Aitcheson & Brown at Cambridge University. The work of behavioral scientists like Kahneman & Taversky led to the upside potential calculation. They had the great ideas; we at PRI tested and applied them. We think they constitute a substantial improvement in identifying managers who can add value.
Measuring performance relative to the S&P 500 is responsible for more bad investment decisions than any thing else. For 25 years, I have stressed the importance of measuring performance relative to the return required to accomplish the investment goal, which in this graph is 8%. Managers should be hired on the basis of their potential to exceed the required return relative to the risk of falling below. And their performance should be measured relative to the required return adjusted for downside risk.
This is my last mutual fund analysis in P&I. I want to thank all those at P&I who have allowed me to present the results of PRI's research to you.
Frank Sortino is director of the Pension Research Institute, Menlo Park, Calif. He also is chairman and CIO of eOmega Solutions Inc., Menlo Park.
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