Calling attention to a problem they help to cause

Karen Dolan has an article at Morningstar about what she calls the biggest cost investors can control.  No, not fees.  In this case, we are talking about performance chasing.  According to Morningstar's calculations, investors have lagged their funds by an average of 1.45% per year due to poor timing.  This is even more than the 0.8% that was paid in fees.

Of course, it isn't news that investors lag the funds they invest in.  Dalbar has been studying this for years.  I did find it interesting, however, that Morningstar was calling attention to this.  Is it really surprising that investors chase performance when Morningstar rates funds based only on past performance?  They hand out manager of the year awards, and even they know that investors will misinterpret these awards.

If you provide data that you know is not predictive, but you also know that investors will misinterpret that data, aren't you intentionally misleading people?

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.

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.