By: Frank Armstrong
By: Frank Armstrong, CFP, AIF
Morningstar just announced their list of fund managers of the year, their annual tribute to the inefficient market. Morningstar is dedicated to the quaint concept that managers actually add value, and that if they just torture enough data, they will be able to select funds that will outperform. Central to the Morningstar approach are the concepts that excess performance derives from superior skill and cunning, and that this superior performance is more than likely to be repeatable.
That the Morningstar database is one of the strongest props for the efficient market theory seems to escape their attention. Using their Principia Plus Database, an investor can screen thousands of funds on over a hundred different factors in as many combinations as an inventive mind can conjure. Yet, with all that data, and all that computing power, no one, Morningstar included, has demonstrated any ability to select managed funds that will do well next year. The absolute, spectacular, cataclysmic and total failure of past performance to predict future performance has been conclusively demonstrated.
We have no better source to document this failure than the Morningstar Database itself. Anyone who cares to is welcome to screen their database for mthe top performers in each category for 1993 to 1997, then examine how these heroes have performed as a group for the following five year period 1998-2002.
With that conspicuous failure in mind, I thought it might be useful to suggest a more rational selection criteria. Concentrating on these issues might actually help investors make more appropriate decisions. Perhaps Morningstar and other fund rating services can at least give this concept equal billing in future editions.
Lowest expenses. Since there is a direct relationship between expenses and return, funds with low expenses will produce better results in your portfolio.
Widest diversification: There is nothing like diversification within a market to help control risk. The widest diversification is likely to be the lowest risk.
Lowest turnover: Turnover generates taxes, and hidden costs not disclosed in the expense ratio. It is distinctly a bad thing for investors.
Style consistency: Investors forfeit any control over asset allocation unless a fund maintains its stated investment style.
Full investment: A fund that doesn’t stay fully invested will have a significant performance drag over the market cycle.
Exposure to unique and valuable asset class: The most valuable asset classes are those that offer appropriate risk-reward trade-offs, and low correlation to the investors existing portfolio. For instance foreign small companies, foreign small value companies, Microcap companies, and small value. Yet, these funds are somewhere between difficult to impossible to find in the retail sector.
Rather than blindly chasing the Performance Fairy, we should concentrate on fundamental elements that generate returns: systematic exposure to fundamental risk factors. Rather than ignore risks, we should reward funds whose construction limits risk. Rather than pretend that costs don’t matter, we should reward low cost funds. Rather than encourage another clone large growth fund, we should be encouraging fund families to expand their horizons into asset classes that offer true diversification benefits.
To be completely fair, Morningstar is not alone in their annual performance rewards. They have lots of good companies including Business Week, Money Magazine, Forbes etc. While these articles may sell magazines and advertising, they are not helpful to investors. Instead, by focusing on just the wrong elements of performance they reinforce discredited ideas, and encourage bad investor behavior. They don’t call it financial pornography for nothing.
Author’s Note: Notwithstanding my previous comments, I’m a great admirer of Morningstar, and proud to have been asked to help launch their web site several years ago. They have done a great service for investors by building a database of funds and performance. It’s hardly possible to overestimate the value of an objective, comprehensive, accurate and flexible database as a research tool and resource for investors. But, we agree to disagree about the usefulness of past performance in predicting future performance. To their everlasting credit, Morningstar allowed me total freedom to publish an opposingviewpoint, restricting their editorial role to improving my grammar, spelling, sentence construction and punctuation.