Can Morningstar's analysts be the new stars?

Morningstar has introduced a new ratings system called the Analyst Ratings in an effort to improve on their not-at-all-predictive Star Ratings.  They use qualitative factors to rate funds as either Gold, Silver, Bronze, Neutral, or Negative.  Morningstar should be applauded for try to reach beyond their Star Ratings based on past performance, but Analyst Ratings probably won't be any better.

Analyst Rating concerns:

• As the Motley Fool points out in their cleverly-named post on the subject, the analyst ratings may suffer from the same systematic positivity as stock analysts.
• This article from Dan Wiener at InvestorPlace points out several inconsistencies in the ratings, such as rating two Vanguard funds that follow the S&P 500 differently.
• The Wall Street Journal points out that the analyst picks and pans, on which the new Analyst Ratings are based, have a pretty poor record.  Only 46% of picks beat their index benchmark.
• They started by rating only about 350 funds, and hope to expand to about 1,500.  Given that there are over 7,000 US mutual funds, it is unclear how they will decide what to rate in a way that is fair.

Analyst Ratings is shaping up to be just another way sell past performance analysis.

More DOL investigations - this time with irony!

Following up on our recent post titled "Investigations into improper advice" about the increasing number Department of Labor investigations into breaches of fiduciary duty, we found an interesting Businessweek article by Anthony Effinger.  The article tells the story of an independent fiduciary being sued by retirement plans for breach of fiduciary duty.  Sounds run-of-the-mill until you see that the independent fiduciary had said, "The fiduciary duty is the highest duty known to the law," when testifying a few years earlier before a congressional committee.

This story reminds us of several facts for 401(k) plan sponsors:

1. Hiring an independent fiduciary does not necessarily shield you from liability.
2. You shouldn't blindly trust people just because (or maybe especially if) they've testified before Congress.
3. Even if you hire outside help, it is a good idea to be informed.

Good data can help you — trust but verify.

It's so you don't get sued

In a post titled, "Why 401(k) Plan Sponsors Should Make Sure Education and Advice is Offered To Their Participants", Ari Rosenbaum points out:

"Studies have shown that the use of investment education and advice has increased the rate of return for participants.  So plan sponsors who want to boost employee morale, one way is to help increase the retirement savings of their employees because better informed participants will make better investment decisions and net better returns."

Education (including, we might add, good quality information about the mutual funds offered) helps make employees happier about their retirement plan, but Rosenbaum's scarier point is, "Offering education and advice goes a long way in satisfying the fiduciary process under ERISA §404(c) to limit a plan sponsor’s liability."

Occupy mutual funds?

Tom Petruno recently wrote an article in the LA Times where he wonders why the anger towards banks has not spilled over to mutual funds.  He brings up the question of how many mutual funds could truly justify their fees.

We think this is a very good point.  Take a key example of mutual funds systematically overcharging: closet indexing.  Let's do a back-of-the-envelope calculation to get at the scale of this problem.

Investigations into improper advice

Ari Rosenbaum's always informational blog recently brought my attention to an article from Drinker Biddle detailing recent "investigations of broker-dealers related to their services to ERISA retirement plans."

The main points are:

1. That brokers and RIAs can act as plan fiduciaries even if they don't acknowledge that they are acting as plan fiduciaries, such as by giving individualized advice.
2. That these same brokers and RIAs could give prohibited advice by recommending a fund when, for instance, they receive "soft dollar" payments.

We think good data can be a part of helping brokers and RIAs show that the funds that they recommend to plans can be trusted.  And we think that plan sponsors can use good data to ensure that the advice they get from brokers and RIAs.

Fidelity Contrafund: How do they do it?

Motley Fool has a recent article by Selena Maranjian about closet indexing.  It does a great job of setting up the problem - indexing is good, but you should pay a low index fund price for it.

The problem, as we have discussed before, is identifying the funds that are closet indexing.  Ms. Maranjian suggests two different ways - looking at top ten holdings or looking at R-squared.  Looking at top ten holdings has obvious limitations when funds often have hundreds of holdings.  And we've discussed the shortcomings of R-squared in this space before.

So what is interesting about this article is that it presents us with a nice little mystery - Fidelity Contrafund.  As Ms. Maranjian points out, "Fidelity Contrafund, for example, has an R-squared of 94.87%, but it has significantly outperformed the S&P 500, on average, over the past five, 10, and 15 years." Taking a look at the top ten holdings as of 9/30/2011, I see recognizable, large companies like Apple, Google, Disney, Berkshire Hathaway, Wells Fargo, and Coca-Cola.

So how does Contrafund manage to outperform?  Ms. Maranjian chalks it up to a few good picks in stocks like priceline.com, Dollar Tree, and Chipotle.  But Contrafund had 453 holdings as of 9/30 - I don't think three good picks tell the whole story.

So I dug through Contrafund's Q1 2011 disclosures to the SEC to get a better idea of how they're doing it.  Morningstar classifies Contrafund as a US Large Cap growth fund, and it's easy to see why when looking at the top ten holdings list.  But it's complete list of holdings tell a different story.  I counted 27 stocks traded on the Hong Kong exchange including not-exactly-household names like "Hengdeli Holdings Ltd." and "Luk Fook Holdings International Ltd."  I also counted 16 Brazilian stocks including "Mills Estruturas e Servicos de Engenharia" and "Diagnosticos da America."  Even it's US holdings are not universally large cap, with small cap holdings like "Gardner Denver, Inc." and "Clean Harbors, Inc."

So my guess of how Contrafund achieves its outperformance while still having a fairly high R-squared is that its large positions are in US Large Cap growth.  However, it "juices" those returns through smaller investments in higher returns categories like small caps and emerging markets.

Now Contrafund definitely isn't a closet indexer.  But it is a style violator.  Why should you care?  Because you carefully select your asset allocation and rebalance annually.  When you select Contrafund as your US Large Cap growth exposure, you're not counting on this hidden overlap with your small cap and emerging markets exposure, so you're not getting the lack of correlation that you should get.  That will lower the effectiveness of your rebalancing going forward.

Finding closet indexers

Academic studies have shown that closet indexing is a big problem.  Studies like the one described in the influential Cremers and Petajisto paper show both that many funds closet index and that funds that do closet index tend to underperform.

So how do you avoid these bad funds?  Christine Benz at Morningstar recently wrote a post answering the question of whether an investor can look at the R-squared of the fund to determine if a fund is a closet indexer, specifically Selected American Shares.  Benz references the Cremers and Petajisto study's active share measurement of holdings overlap to claim Selected American Shares is not an index tracker.  However, R-squared is useful when detecting closet indexers as demonstrated in the recent Amihud and Goyenko paper.  Are we to believe that Selected American's poor recent performance aligning with it's rising R-squared is a coincidence?

Still, Benz is right to point out that R-squared is not a perfect mechanism to use to detect closet indexing.  (Neither is Active Share, but that's a point for a different blog post.)  For one thing, R-squared is calculated based on past performance.  Monthly returns are typically used, meaning you need a good chunk of data (several years) to get real significance.  This means it will fail to find closet indexing that is more short-term.  Studies such as the one done by Chevalier and Ellison suggest that mutual fund managers may closet index to "lock in" a good year.  Such closet indexing may only last a quarter or so, and would therefore go essentially undetected by R-squared.

Using correlated funds for tax-loss harvesting

Abraham Bailin posted a nice write-up on tax-loss harvesting complete with an example trade of selling one fund to book a loss for tax purposes and using the proceeds to buy another fund with a 0.99 correlation to the sold fund.  However, the write-up does not mention how to find these highly correlated funds.

There are no convenient sources for this data today, but Inveska will change that.  Inveska will make it easy for advisors to find statistically correlated funds so they can help their clients tax-loss harvest effectively.

New fiduciary rules coming

At recent post at AdvisorOne by Sherry Christie is among many discussing new rules that could extend the fiduciary standard to brokers.  It seems inevitable that some kind of rule change will happen, although it remains to be seen whether it will be a full fiduciary standard for brokers.

However, no matter what the new rule is, we think it will be important for brokers to prove to their clients that the mutual funds they recommend can be trusted.  Inveska will help them do that.

Good data could help avoid lawsuits

Charles Massimo at CJM Fiscal Management points out that "miseducation" of plan participants can lead to plan participants suing their 401(k) plan sponsor.  He says, "Investment advice is required by law to be in the plan participant’s best interest; however investment education is not subject to this standard."

At Inveska, we believe that the investment data distributed by most 401(k) plans is inadequate, but that good data that is in the best interests of plan participants could help avoid lawsuits.

Consequences for bad funds

The Moneywatch blog has an amazing post by Nathan Hale about a group of employees suing their employer over bad funds offered in their 401(k).  An article by Jilian Mincer and Linda Stern covering the lawsuit reports, "It's one of some three dozen lawsuits filed in recent years in the ongoing tussle over 401(k) costs."  What makes this lawsuit so interesting is that the employer is Ameriprise Financial, who put their own funds into the 401(k) plan.  The employees say that these funds were more expensive than those offered by other managers.

Sure, the story is particularly hilarious when the company being sued is the one that makes the funds.  But remember that all 401(k) plan sponsors are fiduciaries - the interests of the people in the plan go above the interests of the sponsor and the company.

Inveska helps you make sure the funds in your plan can be trusted.

Transparent as a brick wall

Inveska's algorithms are based on SEC-required disclosures that mutual funds must make.  Easy, right?  The SEC has a website, the disclosures are on there, so just go grab them.  It's that easy, right?

Well, it should be.  And for many fund companies, it is.  For Vanguard, Fidelity, Dodge & Cox, and others, it is that easy.

For some, it isn't.  In particular, T. Rowe Price and Franklin put their disclosures in JPG images.  So you can't simply copy and paste the information and do something useful with it.  Take a look at this disclosure from T. Rowe Price Capital Opportunity.

Now, I suppose they would argue one of two things:

1. They are trying to prevent a competitor from analyzing their trades.  Okay, I suppose, except that these don't come out in real time.  They come out a month or so late, so it seems that the competition excuse is a weak one.
2. It's for formatting - it makes them look better.  Of course, Fidelity and Vanguard have no problem making theirs look good without putting all the real data in images.

I think the real reason is clear - they're trying to prevent the very transparency that the SEC is trying to promote with these rules.  And shame on them for that.

You might want to think about that one

I'm sure Christine Benz from Morningstar would like to have that one back.  As recounted in this Moneywatch blog post by Nathan Hale, Benz said:

"You want a strategy that makes sense to you, that intuitively appeals to you.  For example, one strategy I find personally compelling is the contrarian strategy, where a manager is looking for high-quality companies but wants to buy them cheaply.”

Hmmm... as opposed to most investors, who want low-quality stocks that are expensive?  I know what she meant - she is arguing for a value strategy.  Of course, you don't need active funds to get a value strategy -- there is the Vanguard Value Index Fund (VIVAX), for instance.

Although, it is hard to argue that low-cost index funds are not the best option for the majority of investors.  But there are some studies that indicate that among active funds, those that are most active do the best.  We are not as religious about active/passive as Hale, but we do fundamentally believe that if you're going to pay for an active fund, you should get an active fund.

You're on the hook for bad funds

A recent Stuart Robertson article in Forbes should scare some 401(k) plan fiduciaries.  The article's third warning talks about how providers do not share your fiduciary risk.

"And while your rep and provider may have given you a list of funds to select from – and even suggested a few – it’s your responsibility.   The very investment expertise the rep is supposed to be providing is really fully on the employer.  Bad funds?  Your problem.  Employee complaints?  Your problem."

We agree.  If you're a plan sponsor you shouldn't blindly trust your provider.  You should get your own information to be sure you're not being put into a fund solely because of the soft dollars they'll pay.  You need to know the funds you're in can be trusted.  You should share your data with the employees in your plan, too.

Inveska will help.

Don't be a fees patsy

There are good arguments on both sides of the active vs. passive management debate.  At Inveska we don't adhere to one side or the other, but we do want you to get the best value out of your investments.  Evaluate closely all the fees you pay to ensure you are not paying for something other people get for free.  Edward Siedle at Forbes framed it nicely when he wrote, "Remember that a Timex tells better time than a Rolex; a Toyota Corolla is more reliable that a Rolls Royce and a low cost index fund almost always performs better than more costly alternatives."

Don't panic on treasuries, but corporates need fixing

The recent Shifting Bond Maturities and My Latest Mistake post by Mike at Oblivious Investor got me thinking about bonds.  When you're holding bonds, you shouldn't really worry about rising interest rates that much.  Sure, their value would fall, but you would rebalance, buying more bonds, and you would end up holding your older bonds to maturity.  No big loss - the older bonds will approach par value as they near maturity.  The new bonds that you're buying will be yielding more, so you end up doing fine as explained by a Vanguard research paper.  So I agree with Mike - stick with your intermediate term bonds, and don't worry too much about it.

When we get out of treasuries and into corporates, we face a lot more issues.  Among them are that the indexes overweight high levels of debt as Matt Hougan points out on IndexUniverse.  It seems to me that there are some simple tweaks that could be used to improve the indexes.  If we assume that the market is somewhat intelligent and demands a higher yield for a good reason, why not just divide issue size by the current yield-to-maturity?

Credit ratings need to be market-based

It has been a tough few years for credit ratings agencies.  We had the financial crisis with toxic subprime bonds going down at absurdly high ratings.

Most recently S&P downgraded the US Government to AA+ from AAA, which fundamentally makes no sense.  Apparently Warren Buffet agrees.  Now, S&P may be right to be worried about the long-term sustainability of US debt levels.  What I don't understand is how Microsoft bonds can still be AAA.

Let's go through a little thought experiment.  Let's say the US Government starts to get into trouble and bond investors everywhere start demanding higher interest rates.  Most would consider an actual default incredibly unlikely.  It is much more likely that the Fed would ease to drive interest rates back down.  That's right, the government would print their way out of the problem.

But Microsoft issues their bonds in dollars, same as the US.  And oh by the way, they have 51,000,000,000 of those same US dollars on hand - probably sitting mostly in Treasuries.  So a devaluation of the dollar certainly would have a big impact on Microsoft.  So again, if the US government isn't AAA, it is hard to see how Microsoft should be AAA.

Over at IndexUniverse, Matt Hougan wisely points out in his bond indexes post, which I have referenced before, that we should prefer a market-based approach to the question of bond quality.  You can be assured of one thing - Inveska will never take credit ratings seriously.

Swensen explains how mutual fund ratings are no help

David Swensen, former head of Yale's endowment fund and author of one of the best books about investing for individuals, recently wrote a guest editorial for the NY Times. He calls out almost everyone - individual investors, mutual fund companies, regulators, and Morningstar.

About Morningstar's famous ratings, he says "But the rating system merely identifies funds that performed well in the past; it provides no help in finding future winners. Nevertheless, investors respond to industry come-ons and load up on the most 'stellar' offerings."

At Inveska, we agree. That's why we look beyond past performance.

A reasonable portfolio

A lot of effort in the investment space has gone into giving people advice about their proper asset allocation. There’s a good reason for that – academic studies have shown that over 90% of variation in returns is determined by asset allocation. As a result, there’s a lot of advice out there. Academics talk about efficient frontiers and Monte Carlo simulations. Companies such as Financial Engines and Betterment have come along to help people.

Me? I’m more in the William Bernstein camp. The problem is that the inputs to the models are unknown. Things like the risk premium accorded to equities and correlations between asset classes are not very stable over time. Plugging historical data seems unlikely to work – times change, there are different periods, and the future almost certainly won’t look like an average of the past. Having written a Monte Carlo simulator for these types of things, I can tell you that it’s mostly junk. The answers you get heavily depend on whether you think the risk premium for equities will be 4%, 4.5%, or 5%, or other such wonky inputs. I wouldn’t believe anyone who says they know which it will be.

So what do you do, then? I’d start with simply being diversified and rebalancing your portfolio yearly. Also, no matter what you decide, stick to it. You don’t want to introduce unnecessary churn, and you don’t want to chase performance.

Beyond that, here is a reasonable portfolio. It probably won’t be the optimal portfolio over any time horizon, but, hey – it’s worth what you paid for it, and it’s probably just as good as anything else you’ll see.

30% US Large Cap (iShares IWB)
15% US Small Cap (Vanguard’s VB)
20% International (Vanguard’s VXUS)
10% Emerging Markets (Vanguard’s VWO)
5% REITs (Vanguard’s VNQ)
10% Treasuries (iShares IEF)
10% TIPS (SPDR IPE)

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