Morningstar, Lipper, Moody‘s, Standard & Poor’s and other presumably “independent” investment data providers have huge conflicts of interests. One notable conflict that’s rarely discussed in public is the fact that these data-trackers often do contract market research for fund companies, helping them design, structure, deliver marketing programs and rate new securities that are target-marketed back at their own investors. Similarly with credit rating firms whose ratings should protect securities buyers. They are paid by the issuers and failed the buyers of trillions of so-called “triple-A” rated securitized mortgages during the 2008 meltdown.

Moreover, most of the information provided to these data trackers and the SEC by funds and corporations, is anywhere from three months to a year old. And since many funds turnover their entire portfolio holdings more than once a year, you really cannot be sure what they own today. And when it comes to bonds and collateralized debt obligations, the value of underlying collateral may be little more than a derivative of mathematical algorithms and personal guarantees. Another huge problem, their statistics look so beautifully rational and scientific (especially all the “Modern Portfolio Theory” measurements such as the Sharpe Ratio, Standard Deviation, alpha, beta and R-Squared) and yet, studies show that as fascinating as all the data-trackers numbers are to look at, they have virtually no predictive value—they are just cosmetic, window-dressing designed to perpetuate the illusion of rationality.

Mark Twain was right about “lies, damn lies and statistics.” So do you really believe all those sophisticated statistics generated by Morningstar, Standard & Poor’s and Lipper for The Wall Street Journal, Barron’s, Fortune, Kiplinger’s, DowJones MarketWatch and every other financial news sources will help you predict the future performance of a fund? No! And that’s the bottom line in a Financial Research Corporation (FRC) study, “Predicting Mutual Fund Performance II: After The Bear,” This study was prepared five years ago for sophisticated industry insiders, not your average Main Street investors, and given its intended audience. It is one of the most significant research studies available on the value of the statistics that are used by virtually every one of America’s 95 million investors.

“There’s no silver bullet in predicting the future performance of a mutual fund,” says Gavin Quill, Sr. Vice President and Research Director of Financial Research Corporation: “This study tells investors what doesn’t work in predicting the future. In the final analysis, your best strategy is still to focus on portfolio asset allocation, diversification and risk assessment, not specific funds, it’s that basic.” [See "Super-Brain Investing"] FRC’s definition of predictability was very conservative, and should have been easy to achieve. But, it wasn’t for stock funds. “Predictability” simply meant that a top ranking fund stays in the top half of their peer group in future periods. FRC used past and future quarterly returns for fifteen years, comparing average returns for 1-year, 3-year and 5-year periods.

Warning: Most statistics have little or no predictive value for investors

FRC studied five broad mutual fund categories: Domestic equities, International-Global, Corporate bonds, Government bonds and Tax-free securities. Eleven presumably reliable “predictors” were tested, including four risk/volitiliy measures:

– Past performance
– Morningstar ratings
– Expenses
– Turnover
– Manager Tenure
– Net Sales
– Asset Size
– Alpha
– Beta
– Standard Deviation
– Sharpe Ratio

FRC’s conclusions are so significant that you should paste them to your monitor as a reminder for the next time you’re buying or selling a mutual fund and think these stats will make you “feel” rational about the fund’s future.

11 statistical measures—but expense ratio is the only reliable “predictor”

Of all the predictors, the expense ratio is the only reliable one in predicting future performance. Funds with low expense ratios “deliver above-average future performance across nearly all time periods.” FRC calls a favorable expense ratio an “exceptional predictor” for bonds, and a “good predictor” for stock funds. Savvy investors have long known that operating expenses are probably the biggest drag on performance, along with front-end loads and brokerage commissions. Once again, in the FRC study the conclusions are obvious. Bottom line: If you want predictable performance, pick funds with low expenses—and index funds are historically the lowest. Compare these three:

· Vanguard 500 Index (VFINX) No-load; 0.18 expenses.
· Fidelity Magellan (FMAGX). No-load; expenses are 0.59.
· Well Fargo Equity Index (SFCSX). Here’s another passive
index fund that also tracks the S&P 500. But not only is this fund’s
0.63 expense ratio over three times higher than Vanguard’s,
Well Fargo has the guts to charge naïve investors an outrageous
5.75 percent front-end load for a passive index fund that could
be run by a high school kid during lunchtime.

Performance: Vanguard easily wins by a country mile. According to Lipper statistics, for 10 years prior to the study, the Vanguard 500 Index had a load-adjusted after-tax average return 2.3 percent higher than the supposedly identical Wells Fargo S&P 500 index fund, and 2.4 percent higher than Fidelity Magellan’s average return for the prior decade.

Morningstar ratings—don’t let the stars get in your eyes!
Sorry folks, but even the famed Morningstar star-ratings are “not very effective as a guide in finding funds with above average future performance potential.” So, next time you read fund ads, “don’t let the stars get in your eyes!” For example, out of 19 domestic equity categories, the star-ratings had no predictive value in 17 of the 19 categories. Only the small-cap value and technology fund ratings showed any predictive value at the time. In short, Morningstar ratings had no predictive value for the future performance of most funds, including all large-cap, and all mid-cap value, blend and growth funds.

Past performance can’t predict future results
In Barron’s Keys to Investing in Mutual Funds, Warren Boroson says “Past performance of a fund is not a perfect guide to its future, but it is your single best guide.” Maybe not. While the FRC study did find past performance an “exceptional predictor of future performance” with bond funds, not so with stock funds. Past performance was a “moderate predictor for domestic equities only for short-term periods” of one year, but not longer. As a result, portfolio diversification is more important than picking specific funds.

Risk and volatility stats have little predictive value
Worse yet, folks, all those fancy Nobel prize-winning Modern Portfolio Theory measurements of risk and volatility (alpha, beta, standard deviation and the Sharpe Ratio) also have no predictive value of a fund’s future performance. Yes, they may help investors “feel” rational, but they’re misleading. Yes, measures of risk can predict future risk and measures of volatility can predict future volatility. But neither can predict future performance. For example, beta was a good predictor of future beta, except with sector funds. Alpha was a good predictor of future Alpha for bonds, but not equities. And “standard deviation was an exceptional predictor of future volatility” for all funds, but not their performance. And what about the highly-touted Sharpe Ratio? “Unfortunately, this popular measure is not predictably useful” for corporate bonds, international/global or domestic equities. So, the Sharpe Ratio really isn’t too “sharp” when it comes to performance.

Turnover and manager tenure also equally useless
Other measures investors typically use to forecast future performance of mutual funds also have no predictive value—even though brokers, planners, portfolio managers and the press endless hype them. For example: Manager tenure has minimal effect. Portfolio turnover has “no lasting value.” Asset size has “very little relationship to future performance.” And get this: increasing net sales is actually a contrarian indicator. Funds that are increasing sales actually underperform in future years, “suggesting that investors tended to heavily purchase funds right before their relative returns were about to become mediocre or worse.”

Warning, most statistics are misleading, can’t predict the future
Surprise, surprise folks, the world is unpredictable, the economy’s unpredictable, and are the stock market is unpredictable. So, next time you’re considering putting your trust in Morningstar, Standard & Poor’s or Lipper’s fancy collection of statistics, factoids and funny numbers to improve your odds of picking the best-performing funds next year, please don’t do it. Moreover, not only are these numbers virtually useless as predictors, almost all the data is old, reported in SEC filings that are anywhere from three months to a year old. And to further complicate things, since most funds turnover their portfolios at least once a year, the data reported is largely about stocks that are no longer in the portfolio—it’s “old news!”

The truth is, fund statistics are an illusion. They are intended to make you feel rational. But the truth is, you’re being lulled into a false sense of security and mislead into making bad decisions. Except a few rare instances, the FRC study proves that most fund statistics will not help you predict future performance of specific funds. So, if you really want to retire a millionaire, focus on your portfolio’s asset allocations. Remember: “It’s the portfolio, stupid—not the stupid funds.”

Credit-rating “racket” set up subprime mortgage meltdown
The credit rating agencies perform a function similar to fund data trackers, both are agencies presumably helping investors with independent data and ratings—one covering the creditworthiness of fixed-income securities, the other about funds. Unfortunately, the credit agencies—Standard & Poor’s, Fitch Ratings and Moody’s—have as many if not more problems than the fund data trackers. In “Overrated: The subprime-mortgage meltdown could—finally—end the credit-ratings racket” Portfolio revealed “one of the dirtiest little open secrets in the mortgage-ratings world, one that may have played a part in creating the housing bubble.”

A Wall Street Journal was equally damning: “The ratings game: Why lousy opinions cost so much. … Are the rating agencies always the last to know, or just the last to acknowledge a problem? The agencies point out that they rely on facts presented by issuers, and they are not responsible for conducting due diligence. In other words, if S&P and Moody’s are asked to rate a pool of mortgage loans, they don’t actually examine any of the individual mortgages within the pool … investors might ask, what exactly does the rating agency provide?”

Yes, commissioned mortgage brokers were pushing adjustable-rate loans to millions with weak credit, who as it turned out could neither make payments later when the ARM rates were readjusted upwards, nor did they have sufficient equity to refinance in a downturn of real estate prices. But unfortunately, the credit-rating agencies compounded the problem when the home loans were packaged together as collateral for bonds issued and sold domestically and throughout the world.

Credit agencies “too cozy”—manipulate ratings for Wall Street
As the credit crisis accelerated “the big credit-rating agencies were accused of rubber-stamping home loans that should never have been made,” perhaps a third of the total $2 trillion in residential mortgages. And “nobody would have been able to sell any of these bonds without the ratings” according to Marc Dann, the Ohio attorney general, who along with other states attorneys-general, the SEC and Congress began investigating.

Eventually the bond holders realized that “there was no way to determine net asset values that would be simultaneously fair both to investors redeeming from these funds and to investors remaining in the funds,” one $5 billion hedge fund manager told The Wall Street Journal.

Investor confidence lost—can no longer trust rating system
Bottom line: For too long the rating agencies have been too cozy with the bond issuers, lacking true independence and providing no independent verification of the underlying asset values. Moreover, they not only favor the issuers—the folks who pay for the credit rating that investors rely on—they even consult with the issues on structuring the bond so it’ll get the best possible rating.

So the answer to The Journal’s rhetorical question, “what does the investor get,” is very simple: The investor gets a useless opinion based on zero due diligence, that offers zero protection, as we discovered in the wake of the subprime-credit meltdown. The rating agencies are “playing both coach and referee” said Senator Robert Menendez, as Congress demanded more independence. Meanwhile, auditors and accountants began forcing asset write-downs and banks began closing asset-backed securities and mortgage banking operations. The Journal concluded that “investor confidence has been shaken because no longer feel that they can trust the ratings“—a repeat of the same loss of confidence in securities analysts in the last meltdown of 2000-2003. What’ll it be next time?

FirstPubDate: Apr’02