Morningstar Investment Advice: Proceed With (Much) Caution

Despite its massive influence in the mutual fund industry with millions of individual investors and thousands of financial advisors relying on its mutual fund recommendations, the advice is essentially worthless. Past performance of mutual funds says nothing about future performance and a ” five star” top rating by Morningstar has been shown to be useless in predicting future returns. And although you can find some warm words for indexing buried in morningstar’s website and publications, the overall orientation is to push “hot” actively managed mutual funds. What’s more , in recent years Morningstar has moved into hiring analysts to pick hot stocks as well.

So it wasn’t too surprising for me to find the following on Morningstar’s website

Five Domestic-Equity Managers That Deserve More Attention

These managers aren't as popular as they should be

There are several topnotch managers who are household names among fund investors, and there are lots of pretty good skippers who are quite widely known--sometimes due to their own accomplishments and sometimes due to their fund companies' marketing efforts. But there also are a number of first-rate managers who aren't as well recognized as they should be (even though they may have received some external praise or taken on substantive responsibilities at their firms).

Funny thing is, the actively managed large cap Value funds listed in the article failed to beat the Dimensional Fund Advisors (DFA) Large Cap Value Fund.

Here’s the scorecard:

Index Fund:	1 yr Return	3 yr Return	5 yr Return
DFA Large Value Fund	19.33	16.51	13.52
funds cited in article:
Goldman Sachs Large Cap Value	16.89	13.74	11.73
Diamond Hill Large Cap	13.72	17.13	12.06
Diamond Hill Long Short	10.94	17.1	12.35
Bridgeway Large Value	16.16	15.23	n/a
Neuberger Berman Guardian	14.18	12.81	9.17

Not A Single One of the Funds cited in the article outperformed the index fund over 5 years !!!!

For an interesting insight into the Morningstar agenda there is this fascinating article from San Francisco Magazine about Patrick Geddes a former top executive from Morningstar and moved over from the “dark side” to form Aperio Advisors a top financial advisory firm which employs indexing:

One of the company’s founders, Patrick Geddes, aged 48, is a renegade from the top echelons of his field. For several years he served, first as director of quantitative research, then as CFO, at Morningstar, the nation’s leading company for researching and appraising mutual funds. But when he left, not only was he disenchanted with his own company’s corporate environment, he was also becoming uneasy with the moral underpinning of the entire industry. “Let’s be straight,” says Geddes in his soft-spoken but zealous way. “Being unethical is a good precondition for success in the financial business.”…

Geddes, a modest, unassuming son of a United Church of Christ minister, is its chainsaw massacrer. “We work in the most overcompensated industry in the country,” Geddes admitted before the water was served, “and indexing threatens the revenue flow from managed funds to brokerage houses. That’s why you’ve been kept in the dark about it. This truly is the great secret shame of our business.

“The industry knows they are peddling bad products,” Geddes continued, “and a lot of people making the most money and getting the most prestige are doing so by gouging their customers.” And Geddes is quick to differentiate between “illegal theft”—the sort of industry scandals Spitzer has uncovered, such as illicit sales practices, undisclosed fees, kickbacks, and after-market trading—and “legal theft,” the stuff built into the cost of doing business that no attorney general can touch, but which in dollar amounts far exceeds investor losses to illegal activity.

Geddes wasn’t always full of such tough talk about the industry. Not that he had any qualms about speaking his mind; in fact, he was let go from Morningstar in 1996 for being openly critical of the company’s internal culture. “I still think of Morningstar as a potentially positive force in the industry,” he says. “But let’s just say they were weak at conflict management, especially at the senior levels.”

Take a look at the Morningstar website, look at the ads, then figure out if they don’t have a vested interest in promoting actively traded funds. Besides if they acknowledged indexing was the answer they wouldn’t have much of a business in recommending active managed funds and individual stocks.

Ironically the only investment vehicles Morningstar is actively involved in running are the ishares exchange traded funds based on indices developed by Morningstar.