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 Formula

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structure, size, and the legacy nature of a fund portfolio — making it so easy for investors to buy and sell an already outdated model — as an impediment.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).