Looking at Magic Formula returns, Morningstar gets all apologetic over industry performance

Screening 2.0 and beyond

Readers of this site have learned a bit about Screening 2.0 — the ability to use Internet tools (many of them, free) to recreate portfolios that conform to the investment criteria of history’s best investors.

Validea’s John Reese has done much of the research legwork on the subject and has produced a premium product to help investors create Peter Lynch, Ken Fisher, and Ben Graham portfolios (among others).

The magic of  Greenblatt’s Magic Formulamagictrick

One source I mention frequently is Joel Greenblatt’s Magic Formula.  Greenblatt wrote about his investing magic in The Little Book that Beats the Market.  He also provides investors with a free website to screen for the top ranking stocks that fit his criteria at magicformulainvesting.com.

Morningstar takes a look at Magic Formula returns in a recent piece.  Here’s what they come up with:

We see that the formula posted approximately a 19.9% annualized return from the beginning of 1988 through Sept. 30, 2009. Over that time, the S&P 500 Index returned 9.4% annualized.

Not too shabby.

But as a frequent shill for the mutual fund industry, Morningstar feels the need to compare this market-trumping return to top performing mutual funds.  And that’s when things take an interesting turn:  The article’s author, John Coumarianos, sounds surprisingly introspective in his (near) critique of active fund management.

The market isn’t efficient, as the indexers say, but its inefficiencies are apparently not easily exploitable for some of the finest pros either–at least given how many of them currently go about investing, trying earnestly to predict future profits and discounting them back to the present. Perhaps managers outthink themselves or have too much confidence in their predictive abilities instead of relying on past results.

Why funds may perform so badly as a class

The author also cites the mutual fund structure, size, and the legacy nature of a fund portfolio — making it so easy for investors to buy and sell an already outdated model — as an impediment.  Does this mean that portfolio mirroring a la kaChing and Covestor (where investors sync their brokerage accounts up to a professional investor’s portfolio model) has another leg up on the industry?  The separately managed account model (SMA) which institutionalizes this mirroring process does have its benefits, including better tax efficiency (all stocks are held in investor’s name and cost basis is individualized) and transparency (stocks in the portfolio are held in brokerage account).

NYTimes: Insider trading still good indicator for stocks

As a follow-up to The Anti-Galleon Model: 4 resources to insider trade — legally, I just wanted to comment on a NY Times article today by Mark Hulbert called More often than not, the insiders get it right.  The article tracks how insider selling tracked during the downturn in late 2008 and how insider buying accompanied the pickup in 2009.

Couple of things here:

  • Insider selling abated somewhat during a tough January 2010, leading to what some auger as merely a small pullback in the market
  • While typically pretty accurate, insiders “failed to recognize the top of the bull market in October 2007, and didn’t anticipate the depth of the decline that followed.” (according to Hulbert)
  • According to Prof. Seyhun, the axe on insider trading, insiders have been correct far more often than they’ve been wrong, and this is still likely to be the case.

I like aggregate insider buying/selling activity to help forecast market movements but I think it’s even more useful when looking at individual securities.  My gut tells me that seeing the CFO buy shares hand over fist in a small-cap company is more useful that knowing the sell-buy ratio, as computed by Vickers, is 3.51.

The anti-Galleon model: 4 good resources to insider trade — legally

insider-tradingPicking up on recent theme showcasing 6 top resources for following top hedge fund managers (piggyback investing) and the web’s best stock screens, I’d like to spend a little ink on bubbling up the best resources to track insider moves.

Research (much good work has been written about in Investor Intelligence from Insider Trading by finance prof, Seyhun) shows that following senior managers (C-level are the best) from small and midsize firms buying relatively large stakes of their own firms’ stock has beaten market averages.

Here are 4 resources I’ve found online that really help investors looking to mimic the moves of the corporate elite — profiting from insider trading:

  1. Finviz: I’ve written previously about Finviz’s great stock screener.  They also publish a nice free list of all buys and sells from corporate America here.
  2. CNBC: It’s a shame CNBC’s website doesn’t get more props.  While the cable channel has struggled in getting users to watch their videos on the web, they’ve done a great job with the tools on the site.  One tool, Insider Stock Trading Trends, allows users to get a view — by industry — of who’s buying and selling what.  Also drill down on company stock pages — you can plot insider purchases and sales against stock prices.
  3. GuruFocus: This premium site has a few free lists of insider transactions including all those by CEOs and CFOs.  Paying up to subscribe gives users access to insider cluster buys, insider buys coupled with guru buys, and the triple header — companies buying back their own stock, combined with insider and guru buying.
  4. InsiderCow: Nice free site moving towards more to a pay-to-play model. Subscribers can get real-time info as it gets filed, otherwise free offering provides historical inside information.

What do you use?

Cantor’s Movie Exchange and the Future of Trading

In the works for years, Cantor Fitzgerald said yesterday that the firm is expecting to launch an electronic futures exchange in movie box office receipts next month.

It’s called Cantor Exchange and it’s built on top of the Hollywood Stock Exchange (HSX), purchased by Cantor after the dot-com fallout.  The HSX allows virtual investors to buy and sell futures contracts based on the success of movies and actors.

Cantor Exchange will allow investors to do the same using real money.  The movie industry can also find liquidity and leverage in the platform to either hedge their bets with new releases or double-down on movies slated to be successes.

The launch is dependent upon approval by the U.S. Commodity Futures Trading Commission.

What it all means: investing, markets, hedging

Online forex is on fire.  Just check out the recent filing for an IPO by one of the largest players.  Peer to peer lending has proven tricky, yet popular.  Case Shiller housing indices have spawned options, futures, and even exchange traded products to capture changes in housing prices.

Given the popularity and predictability of the HSX, there is no reason to think that box office receipts won’t also enjoy success.  What’s interesting here is how the Internet is empowering the creation of new markets — allowing speculators the chance to profit and other participants the opportunity to hedge.

Read the fine print, investors: Some mutual fund fees higher than thought

We’ve written for a while that for certain purposes, Exchange Traded Funds (ETFs) are a better mousetrap.

As Mutual Funds 2.0, ETFs have introduced:mousetrap

  • new ways to implement investing ideas (eg. country exposure to Poland, Chile, etc.)
  • made existing ideas easier to trade (leveraged long and short funds, buy-write strategies)
  • provided continuous pricing (unlike Mutual Funds that price once at the end of the day)
  • more competitive management fee structure (ETFs are typically passive investment tied to an index)
  • eased the tax burden (some ETFs are able to pass on very little capital gains to the investor either through legal loopholes or just low turnover of the portfolio)

Mirroring as a new investment model

What’s true of ETFs is also true for new investment models, called mirroring.  Trade mirroring allows investors to synch their online brokers with a portfolio manager’s every move.  Unlike a traditional mutual fund manager who pools assets together, newer structures have portfolio managers managing a theoretical model (3% in X, 5.5% in Y, etc.).  This model is executed in client accounts (which are typically held elsewhere).  When a portfolio manager makes a change in the portfolio, it is then mirrored in the client account.  See this example of a mirrored account that tracks Warren Buffett’s moves.

Pricing is typically competitive to similar mutual fund strategies and investors pay a management fee + some fee whenever a trade is executed in their accounts.  Because assets are held in the investor’s own account and not comingled (like in mutual funds), the investor never has to share in gains or losses of the fund as a whole — in fact, the investor has some leeway to practice tax loss selling as well to pair losses vs. gains.  In this sense, mirrored accounts are much more tax efficient when compared to mutual funds.

Brokers have sold these types of accounts for years, called Separately Managed Accounts (SMAs), where investors could get access to some of the world’s best asset managers with just a fraction of the assets typically required to access these managers.  Now, we’re seeing the same models rolled out to do-it-yourself (DIY) investors.

It’s these last 2 benefits of newer investment vehicles – lower management fees and softer tax burden — that’s become an interesting bone of contention in the ongoing tug-of-war between the mutual fund industry and new emerging types of asset managers (including, but not only, ETFs).

Disagreement over *real* pricing

kaChing, an expert investing community which allows investors to invest alongside rising-star portfolio managers, recently introduced its own analysis (along with help from Lipper), that shows the average fees charged by mutual funds are much higher than investors typically realize — averaging over 3%.

In an article last week on the Wall Street Journal entitled “Mutual Fund Fee Debate Heats Up” (sub required), Ian Salisbury compares kaChing’s findings to those of the mouthpiece of the mutual fund industry, the Investment Company Institute (ICI).  As the WSJ reports that the ICI’s tally of the average fees charged on mutual funds hovered just over 1%.

So which is it — >3% or >1?  Clearly the answer is very important for investors.  Why? Because investing is a simple formula:

Net investment returns = Gross investment returns – taxes – fees

Given that higher taxes eat away at any return we get, lowering taxes is extremely important.  If kaChing’s numbers are correct, there’s no way the average mutual fund can even come close to beating the markets.

Couple of caveats to think about here:

  • We’re dealing with averages here:  If the average mutual fund (with 60% turnover per year, as per the ICI’s 2008 Factbook) passes through such a high tax burden to its investors loses versus index funds, that’s not to say that certain funds do charge less and return more.  Let’s not throw the entire mutual fund baby out with the fee bathwater.
  • kaChing’s execution costs for high turnover portfolios: kaChing will be producing a side-by-side analysis of their typical costs vs. those of the average mutual fund in the upcoming moths.  While kaChing (and competitor, Covestor) may indeed have lower management fees and be a lot more tax sensitive for investors, their execution costs (typically $.02/share) will eat up gains.  High volume turnover will still eat into profits.  Investors will continue to pay for professional portfolio management.
  • Transparency typically benefits the investor: It’s hard to tell exactly what mutual funds charge their investors.  Consequently, firms like kaChing are competing head-on with mutual funds and appealing to average investors by attacking the industry’s Achilles Heel: transparency.  They are banking that, as social media’s Facebook and Twitter phenomena have created new levels of visibility, so too investors will demand it in the financial industry.
  • Fees are important but not the only factor: Too many times investors will forgo professional management because they feel the fees are too high.  While that may be relatively true, there are other factors on which an appropriate investment must be sized up (risk-weighted returns is a huge one for individual investors to better understand).  Everyone on all sides of the aisle is trying to sell you something — caveat emptor.  There are no free lunches.

Anyway, check out the kaChing analysis, read what the WSJ had to say, and I’d be interested to hear your feedback.

Investors and Google Buzz: a threat to StockTwits?

With much fanfare yesterday (they even arranged a blizzard for much of the googlebuzzU.S.), Google announced its social media offering, Google Buzz (see video below).

What is Google Buzz

So, what is Buzz?  I like Matthew Ingram’s description on GigaOm of the Google Buzz service:

Google’s new service looks and feels a lot like many other social media tools and networks. The primary input is a box for status updates, just like Twitter and Facebook. You can use @ replies, just like Twitter, and you can share photos and other media content easily (there’s even a photo gallery function like Facebook’s). If you’re mobile, you can give Google Buzz your current location and get comments about that location, just like Foursquare and Gowalla and Yelp. But the single biggest difference between Google Buzz and all of these other services is that Buzz is tied to email.

I think what’s interesting here is that it looks like a take on Twitter and Facebook that will allow more intellectual collaboration.  And by that, I mean an ongoing, multimedia, conversation centered around specific content.

How Investors use Social Media

Beyond the back-and-forth whether Google Buzz is a big hit or flop, I began thinking how investors could use this service. When I do this (it’s a messy process, sorry), I tend to use the New Rules of Investing framework.  Investors using social media tend to piggyback gurus (cloning super investors’ portfolios a la AlphaClone), crowdsource ideas (like Piqqem), participate in expert communities (like Covestor and kaChing), and use new technologies to better screen for investments.

StockTwits: What it does

We all know of the initial successes of StockTwits — it’s a good service, run by competent, thoughtful people and has created a pretty loyal (can I say, rabid?) following of users.  Built on Twitter, StockTwits layers in functionality specific to traders and investors (they’ve even skinned their own Twitter software client).

StockTwits users are plugging into what I call (in my upcoming book) the Tradestream: online investors’ publicly available trading logs, complete with their thoughts and theses behind the trades and market conditions.  These are short thoughts, 140 characters or less in length, and typically stand alone.  It’s hard for someone participating in a conversation — let alone, someone who is merely a spectator of one — to group together thoughts into a cohesive conversation (think of how Gmail deals with emails/chats as part of a discussion).

How Google Buzz improves on Twitter/StockTwits

Google Buzz changes this.  Buzz groups thoughts, however errant or short, together into an ongoing discussion.  For example, assume someone posted their thesis on whether Google (GOOG) is a long or short candidate.  In yesterday’s pre-buzz world, an investors would use StockTwits’ Twitter client and post, “Thinking Google’s a long here.  Any thoughts?”.  This would be followed by a string of responses over the next few minutes and trickling in over the next couple of hours.  To view this unfurling chat, users could check the StockTwits Google Page online or access this data through a Twitter client.

But, and here’s the thing, there is nothing cohesive pulling these scattered thoughts into a conversation to help me make a decision regarding GOOG.  Of course, I can scan the output — the tradestream — and piece it together myself.  The power of the conversation is lost on Twitter and instead turns the stock research process into an incessant deluge of sound bites. That process of vetting ideas is especially important to investors.  This is not a ding on StockTwits as much as its the product of how Twitter works.

Google Buzz changes this.  And more, it inserts the tradestream into my email client, where I’m already spending my time — not a game changer, it just enables me to close one more window.

Is this something StockTwits can address?  Surely.  Howard Lindzon and team understand what investors/traders are looking for and are rolling out tons of functionality (have you seen StockTwits TV?  Loving it, actually).  It’s this focus on the investor/trader/analyst that will continue to trump Google’s more general efforts in this space.

Thoughts?

The Web’s Best Stock Screens: Looking for the next winning investment

fish_netStock screens allow investors to sort through lots of different stocks in search for only the ones that fit certain criteria.  Investors looking for the next stock pick for their portfolios can use basic screening tools, available at both Yahoo! Finance and Google Finance. MSN recently retired its highly-regarded stock screening tools, leaving what’s freely available somewhat lacking.

Screening 2.0, something I like to discuss on the site, provides the same outcomes but incorporates more algorithmic know-how, some artificial intelligence (how do you deal with an infinite P/E one year?), better ability to backtest results, and preset criteria to match results of the world’s best investors.

I decided to piece together a list of some of the Internet’s best free and premium stock screening resources.

So, here goes:

General Investing

  • Validea: One of my favorites and started by author of The Guru Investor, John Reese.  Validea is a premium service that tracks screens preconfigured with the investing criteria of history’s greatest investors, like Buffett, Graham, Peter Lynch, Ken Fisher, and more.
  • Finviz: Lots of stuff going on here. IMO, the most powerful, free screener available.  With fewer preset screens, Finviz is for more advanced investors who have specific criteria they look for in stocks.  A whole lotta descriptive, fundamental, and technical ways to sort for new ideas.
  • Manual of Ideas: Mentioned in my post from last week, Top 6 Ideas for Piggyback Investing, MOI has both free and premium screens like 10×45 Bargain Hunter, European Value Report, Equities and Tobin’s Q.  These screens come in form of subscription newsletters (again, some free, some premium) with more analysis included beyond the output of the stock screens.
  • AAII Screens: Blown away by how many screens the American Association of Individual Investors has on its website (you have to join AAII to access these screens).  You can find growth and value screens with preset parameters (like IBD Stable 70 and CAN SLIM) as well as guru screens that look for specific investment criteria established by famed investors like Graham, Buffett, Dreman, Lynch, Zweig, etc.
  • Zacks: Nice combination of some free screens (Earnings & Margins, Growth and Income) and premium screens (Zacks Rank 1)
  • CNBC: lets users save custom made screens and also has a few prepackaged screens for free
  • The Kirk Report: Couldn’t be remiss in mentioning the great screens Kirk puts together for subscribers to his service.  He calls his screens, the Stock Screen Machine.
  • The Motley Fool’s CAPS: Nifty free screener that incorporates the community’s CAPS ratings into the screens. Allows users to download results to spreadsheets.

Value Investing

  • Old School Value: Nice site with numerous free screeners for all kinds of value investing
  • MagicFormulaInvesting: Built by the man, himself — Joel Greenblatt, this is a nice free site to do basic screening for stocks that fit the criteria of the Magic Formula

Institutional Ownership

  • AlphaClone: Of course, this hedge fund slicer-and-dicer is a stock screen of sorts.  This premium product (read my review here) allows users to identify the top performing funds, peer into their holdings and backtest their strategies.

Insider Buying/ Selling

  • GuruFocus: Interesting free and premium offerings that track top guru buys as well as insider transactions.  Can download results into spreadsheets for more analysis.

Technicals

  • StockFetcher: Nice premium screen for technical investors encompassing Bollingers, Candlesticks, Moving Averages, and more. Output is downloadable to Excel.

I am SURE I left really good tools out — let me know in the comments if you think I should include something I’ve missed.

ETFs, overindexing and the power of financial brands

Just doing some thinking about the growth and future of the ETF industry:

In my eyes, ETFs began as a second-generation of mutual funds with the following characteristics:

  • Passively managed: ETFs were passively managed (though that’s changing), building upon Jack Bogle’s success at Vanguard.  Most research at the time clung to the Efficient Market Hypothesis and academics declared that trying to beat the markets was a fool’s game.  ETFs were this vehicle.
  • Cheap: They were cheap.  If theory shows that you can’t pick stocks and win the game that way, better to index and reduce fees for better long term success.  ETFs’ passive structure enabled fund sponsors to get big and compete on price, driving prices further downward.
  • New access: Beyond their philosophical underpinnings and reduction in asset management fees, ETFs also opened doors to new asset classes (commodities), markets (Peru), and strategies (leveraged short funds) that weren’t easily accessible or understandable for retail investors previously.

Things are a’changin

Things are changing.  With Blackrock’s purchase of Barclays Global Investors iShares (BGI), ETFs are no longer seen as a pure threat to the much larger mutual fund industry.  Diversified asset managers like Blackrock and PIMCO, mutual fund firms like Vanguard and Fidelity, and online brokers like Schwab are building and buying ETFs as part of a larger smorgasboard of choices for their clients.  ETFs fit in like precious metal and international funds into a firm’s offerings.

In a sense, ETFs have now become purely productized, competing against similar strategies in different structures.  Contributing to this trend is the fact that numerous ETF offerings targeting the same strategy/geography have all hit the market. With multiple offerings for almost every market and strategy in ETF land, overindexing has blurred any and all distinctions in investors’ minds about which securities to select.  Instead of doing the work to pick the most appropriate security, brand will ultimately trump other things.

While there may be 3 general, broad ETFs for investors to get Chinese market exposure, most retail investors have no idea that they’ve been structured differently, that the compositions of the indices these ETFs track are wildly different and have led and may very well lead to different performance outcomes.

Brands, brands, brands

What this means, then, is (like most things in life), competition in the ETF space gets muddled.  ETFs compete against mutual funds every bit as much as they do against each other and with this backdrop, the emergence of the firm’s brand will trump performance and index structure.  Index composition or the race to build a better mousetrap becomes less important.  Branding will sway investor decisions and assets away from the smaller, more innovative players, towards the larger, stronger brands.

Like everything commercial, brands wield power.  So true in the financial sector as well.

stock screen, screening 2.0, investing, warren buffett, peter lynch, dreman

As if we needed another study to spell this out, S&P published a recent study (.pdf) that undermines the hot money chasing performance in the mutual fund industry.  The study shows that very few funds demonstrate persistence — the ability of asset managers to consistently achieve top-quartile or top-half performance.

The amazing take-away from the study:

Over the five years ending September 2009, only 4.27%
large-cap funds, 3.98% mid-cap funds, and 9.13% small-cap funds maintained a top-half ranking over the five consecutive 12-month periods. No large- or mid-cap funds, and only one small-cap fund maintained a top quartile ranking over the same period.

Couple of things here:

  • Not one large-cap or mid cap fund maintained top quartile ranking.  Should investors just use large cap and mid cap indices for their exposure here regardless?
  • While still posting rather poor results, there are twice the percentage of small cap funds achieving top-half performance than large caps.  There still seems to be significantly more value in active portfolio management in the small cap arena.

The study’s ultimate takeaway:

Our research suggests that screening for top-quartile funds may be inappropriate.A healthy plurality of future top-quartile funds comes from the prior period’s second, third and even fourth quartiles. Screening out bottom quartile funds may be appropriate, however, since they have a very high probability of being merged or liquidated.

Compare that to the findings of Jagannathan, Malakhov, and Novikov in “Do Hot Hands Exist Among Hedge Fund Managers?”:

We find evidence of persistence in the performance of funds relative to their style benchmarks. It appears that on average more than 25% of the abnormal performance during a three year interval will spill over into the following three year interval.

[Hat tip: Pragmatic Capitalist]