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?

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.

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.