Do Morningstar’s ratings work or not? (revisited)

Last week in the WSJ, Joe Light shined some light on a study that took issue with Morningstar’s ability to forecast winning mutual funds.

The paper looks at Morningstar’s overweighting of “corporate culture” as the major input into what the research firm calls, “corporate stewardship”.

Corporate culture is one of the mushier components, answering questions like “do talented investors spend their careers at this fund firm?”

To see what value the culture rating adds, Pace University professors Aron Gottesman and Matthew Morey took Morningstar’s corporate culture ratings and compared them to fund performance between 2005 and 2010, finding that the two don’t necessarily go hand-in-hand. (Can Corporate Culture Predict Mutual Fund Performance)

Morningstar responds

Well, the mutual fund rating firm wasn’t going to let this slide without a fight. The WSJ published Morningstar’s retort:

Continue reading “Do Morningstar’s ratings work or not? (revisited)”

Tradestreaming Cascade for the Week ending May 1, 2011

A new addition to Tradestreaming, the Tradestreaming Cascade is a highlight reel of some of the past week’s most interesting information. Much of this comes from my Twitter feed, @newrulesinvest

Research update: Activist Investing (The Activist Investor): More research into the value extracted by activist investors — this time looking at shareholder proposals and voting.

The art of investing in today’s economy (Tradestreaming): New podcast with the former personal finance columnist for the WSJ, Jonathan Clements.

Favorite Boutique Asset Managers Launch New Funds (Morningstar): Ariel, Fairholme, Royce, FMI among the firms launching new mutual funds with interesting strategies.

May 3rd poorest performing month in pre-election years (Stock Trader’s Alamanac): A hypothetical $10k investment in the DJIA for November-April would have compounded to over $500k (1986 – present) while May-October would have resulted in a $379 loss.

Sectorology: How the financial sector stacks up against other industries (Random Roger): Interesting view on short-term, long-term investing in financial stocks.

The predictive power of the combo of Morningstar stars, expenses, investor returns, manager records and active share (Morningstar): More Morningstar research on how best to use their information for profitable investing.

Online brokerage no threat to advisors? Yeah, and I’m a meat-eating rabbit (New Rules of Investing): Redefining the role of brokerage and advice in the age of social media.

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

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).

Recommendation for Tradestreaming from Michelle Leder,, a Morningstar Company

Zack Miller is an excellent source when it comes to using new online tools to vet investment ideas.  His first book is a broad survey of emerging investment strategies that take advantage of the wide array of financial tools and content that you can find online — from blogs to Twitter. There’s a lot of noise out in the tradestream, but this book helps you cut through that to find the information that’s truly useful. — Michelle Leder,, a Morningstar Company