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 I really outsource my fiduciary responsibility?

Investing is complicated enough, and when you throw a bunch of Department of Labor regulations into the mix, things get even more complicated.

So as this article in Investment News points out, many are reacting to this by trying to outsource some fiduciary functions:  "The solution involves outsourcing fiduciary functions, and several investment advisory firms — chief among them Morningstar Investment Management, Wilshire Associates Inc. and the advisory arm of Mesirow Financial Holdings Inc. — now are providing investment menu design, fund selection, market commentary and other services to small-plan sponsors and the broker-dealers and insurers who sell such plans."  Who can blame them?

But wait, look a little further an you'll see this little tidbit: "Acting under Section 3(21) of the Employee Retirement Income Security Act of 1974, an asset manager becomes a co-fiduciary and shares fiduciary responsibility..."

So, as Ari Rosenbaum also points out, plan sponsors are still on the hook.  There is just no easy replacement for understanding the fund lineup being offered and making sure the plan participants have the information they need to make good decisions.

If we could design the mutual fund landscape from the ground up...

Our previous post discussed the poor results of mutual funds in 2011 at least partly due to the prevalence of closet indexing.  So it was refreshing to see that one company is doing something really different.  This article in the Christian Science Monitor talks about a new fund from Gamco Investors called "Focus Five."  A full 50% of the fund will be invested in only 5 stocks — what the company calls its best ideas.  The remaining 50% of the fund will still be focused relative to the rest of the market, investing in between 10 and 20 stocks.

Now, it remains to be seen whether Gamco will be any good at stock picking.  But whether they fly high or crash and burn, you'll at least know why.  Their disclosures will be crystal clear, leaving no mysteries, so that it will be easy to hold them accountable for their picks.

It makes one think about a different way mutual funds could be built if one had the opportunity to rebuild the ecosystem from scratch.  One could imagine that investors desiring active management would split each asset class exposure between two funds - a passively managed index fund and a small, highly focused fund with few holdings.  Investors would then get their market exposure cheaply, as they should, in a fund that is an index fund and says so.  That wouldn't be muddied together with active picks — bringing transparency and accountability to those picks.

It will probably never happen — investors may not like the complexity of using lots of funds, and they could hurt their returns badly if they overload on a single, badly-chosen focused fund – but it's an interesting idea, and one we may hear more about if Gamco has success.

2011: A terrible year for mutual funds

A Businessweek article by Lu Wang last week which reported on the terrible year mutual funds had in 2011 should give investors a lot to chew on when selecting funds.  The facts are stunning – only 17% of actively managed large-cap funds beat their benchmark.  What might this mean for investors going forward and what are the implications for how mutual funds are rated?

We have written about closet indexing before, and it's important to consider that 2011 may be a result of the trend noted in some academic studies that closet indexing is increasing.  The Businessweek article also points out that correlations among stocks were at a record high in 2011, making stock picking more difficult.  This is known to happen in rough times before, but what good are historical analyses if such fundamental things can change so quickly?  Would something like Active Share be a better measure to use in such times?

There are many open questions, but we do think that in times like these, analysis based on holdings could give investors a valuable, different view into funds.

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.

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.

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.

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.

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.