Mutual funds

In the last post Nate had asked about the evaluation of mutual funds. Well it is my opinion that mutual funds are not evaluated very well.

First of all, the principal evaluator of mutual funds, Morningstar, has less than perfect methods for evaluating the funds. That organization has high turnover. After all, many of their analysts were not talented enough or highly regarded enough to land a job on Wall Street with one of the investment banks, or with one of the 10,000 mutual funds in the U.S. So Morningstar is a second tier gig for those folks. Frequently what happens is that once they get some experience at Morningstar, they will turn that into an opportunity at a more prestigious and better-paying firm.

Second of all, Morningstar is overly weighted to analytical evaluation tools. The problem with this is that you can only analyze facts and facts are only pertinent to the past and investing is an activity whose benefits unfold in the future. This disconnect means that too much numerical analysis results in improper evaluation. In effect, Morningstar is always “fighting the last war.” This means that they identify strong money managers of the past and the assumption is that they will be good in the future. This is like forecasting the weather today by saying it is likely to be just like yesterday. It works well mostly, but it absolutely misses changes in the weather, right?

Third of all, the Morningstar analysts do interview portfolio managers (I was one of their analysts’ perennial “Analyst Picks”). However, they really don’t have enough information or expertise at their disposal to ask very tough or pertinent questions. Not only that, but they are reliant upon the fund that they are evaluating for information about that very same fund. That is an inherent conflict of interest, isn’t it? Thus, in my history as a Portfolio Manager I felt that I was only ever asked a tough question a couple of times. And in the grand scheme of things they were pretty tame.

So how do you evaluate mutual funds? My advice is to steer clear of them and to actually invest some few months of your life to learning how to make you own investment choices. I am certain that your returns will be better than that of the average, and even above-average, mutual funds. Why? There are a number of regulatory hurdles that make managing a mutual fund less than ideal if you are a pure investor. In other words, the regulators, while well-intentioned, actually hamper results.

Now I know what you are thinking: Jason, you think there should be more regulation, not less, so how can you have made that statement? I think that mutual fund regulation does need to be increased. But I also feel that the current regulations regulate the wrong things.

Did you know that it is a dark and dirty little secret that most mutual fund firms do not conduct their own proprietary financial analysis? Huh? What? It’s true, I promise. Most of them rely upon Wall Street investment banks’ analysis. In return for this free analysis they conduct their asset trades through the firm in order to pay the firms back for the free analysis. The Davis Funds, my former employer, was one of the handful of firms actually conducting their own analyses. I kid you not. This despicable fact is one of the reasons that I am not a big fan of mutual funds and one of the big reasons for my wanting to publish an investment opus. That is: to empower YOU.

So, assuming you do not want to learn to do your own financial analysis, what should you do? Look for mutual funds that have very low turnover – less than 40% – and preferably around 15-25%. Turnover is how often they buy and sell securities within the fund. The lower the turnover the lower the transaction costs and the greater the likelihood that they do their own analysis. It is impossible to have a turnover of 100% and with a straight-face say that you do your own analysis. That 100% means that in a year all of the companies you owned at the beginning of the year are gone by the end of the year. What is the point of engaging in the expense of the analysis, if you are only going to hold for a year? Most funds have turnovers in the mid-100% range! If you take the inverse of the turnover ratio, say 1 / 20% = 5, you get the average holding period in years. So 1 / 300% = 0.33 years, or 4 months. That is actually very common.

Next choose managers who have been at the helm of their fund for at least 3-5 years. It takes a while to have an effect on a fund’s performance. It’s not like the day you get promoted you walk in and sell all of the previous manager’s holdings and then buy your own. No, instead, it takes about 3 years to truly have an impact on a fund’s performance. Also, if the tenure is 3-5 years the fund manager has greater experience in managing a fund – this is a good thing. The primary difference between being an analyst and a fund manager is that the analyst aims the gun, while the portfolio manager pulls the trigger. In other words, it takes a lot of courage to take on the responsibility of managing a LOT of money. That responsibility can be daunting and it takes awhile to get used to the pressure.

Next, choose managers that do their own proprietary research. At least if they fail you will know that they failed based on their own intelligence, and not someone else’s. This can be very difficult to discern. Last year I interviewed with a firm up in Seattle that claimed to do its own proprietary research on its website. Yet when I was sitting down with the person who would be hiring me, and asked them about their “proprietary” research they said that they relied upon Wall Street investment banks for the actual company research, but that they had a proprietary trading model that told them when to buy companies. Oh, brother! By the way, at the time, this money manager was ranked 5-star by Morningstar. How can you tell if they do their own proprietary research? Ask to speak with a wholesaler at the firm and see if you can get your hands on a copy of stale research.

Lastly, choose money managers that are honest. You can evaluate the honesty by reading their semi-annual reports to shareholders and look for the admitting of mistakes and the lack of rationalizing language. Look for managers whose language you can understand. If they are interested in serving you then they should be interested in communicating with you, too.

Have a good weekend!

Jason