Morningstar vs. The Wall Street Journal...Does It Really Matter ? Not in My Opinion

The WSJ recently had a lengthy article critical of Morningstar and the use of its star ratings. It found the lack of persistency in the star ratings, the use by some advisors of the star ratings as a shortcut in justifying fund recommendations to clients, and the use of fund ratings by mutual fund companies to tout their funds.

This sparked a series of fevered responses by Morningstar here and here and here
For instance one argument by Morningstar's CEO is

• The Journal sees little predictive value in the star rating, but the results show that investors were far likelier to succeed with 4- and 5-star funds over subsequent periods and much more likely to fail with 1- and 2-star funds, on average.

Morningstar also stresses that the ratings "should be used as a starting point" for research.

I could go though and analyze all the back and forth between Morningstar and the WSJ over the star system. But in fact with regards to actually choosing an investment strategy the star system is irrelevant...because it is fundamentally a rating system among actively managed funds (usually how well they do against the relevant index) and actively managed funds should be eschewed in favor of index funds or ETFs.

In the WSJ vs. Morningstar "smackdown They are simply debating a syatem that ranks a a group of investments that should be avoided.

In fact to be fair to Morningstar if you dig down Morningstar often  has some pretty good things to say about indexing and authors that recommend portfolios often make heavy use of index funds. And if you dig even further you will find Morningstar authors stating that the best predictor of future fund performance is the level of fees (not those star ratings). The message is somewhat buried of course because Morningstar's core business is ranking actively managed funds. Telling everyone to forget 90%+ of the funds they rank and just index wouldn't be very good for business.

One author that constantly shows a bias towards indexing is John Rekenthaler who writes on the morningstar advisor website aimed at professionals. In fact in his most recent column he writes

Two weeks back, Barry Ritholtz of Ritholtz Asset Management and Nir Kaissar, a Bloomberg columnist, discussed the merits of active versus passive investing. The debate's outcome was a foregone conclusion; these days, few if any investment writers wholeheartedly support active management. They either recommend passive investing fully or they advocate blending the two approaches, typically by starting with a core of passive investments and then adding active funds as desired.

But Rekenthaller was also on the warpath with the WSJ on the main consumer website with no mention of the indexing alternative and plenty of arguments on how to evaluate the star rating system. The article was enttled Statistical illusions But there is one set of statistics most important to investors that are not an illusion..they should avoid actively managed mutual funds...period/

Just as there is little or no persistency in the star ratings for the actively managed funds it should not be surprising  there is no persistency of returns in actively managed funds vs their relevant index. In fact the only reliable statement that can be made about actively managed funds is that the vast majority of them will fail to outperform their relevant indices.

I didn't even realize how terrible the record is until the always excellent blogger Ben Carlson posted this chart (click to enlarge)

In sum the debate over the efficacy of Morningstar ratings is a case of "looking for the keys under the lamplight". If you are looking for the best choices for your investments then active funds are not the place to look.

Does that mean Morningstar is useless ?...not really if you use their material correctly. Don't even look at the star ratings, don't even look at the actively managed funds. But Morningstar includes a wealth of data about ETFs which can be used for research.  With hundreds of ETFs including multiple ones in basic categories like small cap value Morningstar can offer a valuable tool. I do think the difference in long term performance among ETFs within as market sector can be relevant to an asset allocation. In addition the Morningstar analysis allows one to drill down on the holdings and methodology of the ETF. Very useful data on individual ETFs is also available at ETF,com. So the investor can do some very useful research on various index instruments within categories in Morningstar.

Morningstar has an additional very useful tool I believe in only its premium service. It is something called stock overlap. It is a tool that allows one to analyze an entire portfolio with regards to data such as geographic and industry distribution, p/e, market cap  and percentage of an individual stock in a portfolio. For example since Apple has a high weighting in the overall stock index, the momentum ETF Mtum and large cap growth ETFs like VUG the Morningstar tool is extremely useful in calculating the overall exposure to Apple in a portfolio holding these ETFs.

A very interesting article explaining another way of analyzing overall portfolios appeared at etf.com.in this case with "factors" It can be forund here..

So my conclusion about Morningstar: forget about the stars..and the WSJ/Morningstar debate over them. Forget about using actively managed funds. Make use of the Morningstar material on ETFs and Index instruments (as well as other data such as the excellent material at etf.com) and construct a diversified portfolio of index instruments, rebalance and stay the course.

Richard Thaler and Your Investments

Richard Thaler's Nobel Prize is yet another sign of the growth of behavioral economics as a dominant part of the field of economics. Others behavioral economists that have won the Nobel Prize was Daniel Kahaneman (2002)Kahneman was actually a Psychologist and Thaler's mentor,, and Robert Schiller(2013). The fact that both Schiller and Thaler have been heads of the American Economists Association says much about the "mainstreaming" of behavioral economics.

Thaler put his findings susinctly "the only people that think humans are rational are economists" Or as I like to say "it ain't physics"Thaler's latestbook Misbehaving gives his intellectual biography and thus a history of the field. His previous book(written with Cass Sunstein Nudge showed how public policy and other decisions can influence behavior and was used in both the UK and US as an input to policy decisions. In my view it was the only case in which policies based on an academic economist were implemented and led to results which virtually everyone views as positive,

I would put the findings of Thaler into two categories of relevance to investors:

Forced savings: the most practical implementation of Thaler's theory was his success in getting 401k plans to incorporate automatic enrollment thus implementing automatic payroll deductions to go into a retirement account (of course people are free to opt out..but the overwhelming number do not do so). Based on a "rational economic man" expectation there would be no difference in the number of employees enrolling in such plans if there was a choice available or if the enrollment was the automatic/default selection. Of course if that wasn't the case and there was no open enrollment the theory would be proven wrong in 401k plans increased tremendously when the automatice deductions was implemented. Regulations regarding 401k plans were altered in 2006 to allow plans to have automatic enrollment and participation by employees has increased as a consequence.T

The implications for individual investors is clear the more one sets up an automatic transfer from checking/savings accounts into an individual investment account the better for building a retirement portfolio (rather than making decisions about each transaction. Also it makes sense to opt for the maximum possible 401k contribution (which is not the default option in automatic enrollment plans)

Investor behavior. 

Loss Aversion. In a 'rational world" an investor would always choose the possibility of a coin flip (investment) in which there was a 51% chance of a gain of $101 and a 49% chance of a loss of $100 (higher expect return for the former) but in fact the number at which investors would demand a gain far larger than the loss to make the rational (higher expected return) choice tolerate a potential loss in  is far far higher.  Investors feel more pain about a loss than pleasure at a gain, Not surprisingly one of the consequences for this that  the more often an investor checks his account value (more likely to find short term losses) the more often he will sell his investments.

What is the consequence of the above ? Investors systematically under allocate to stocks relative to bonds given the risk return characteristics of stocks and bonds. This is particularly the case if investors are presented with short term data as to past behavior of stocks and bonds (which of course show more down periods than long term data). This behavior could also explain "busts": sharp down moves in assets as investor show loss aversion. In my personal experience working with clients I have at least two take aways: when presenting allocation proposals to clients stress long term data and the commitment to have discipline and 2. the academic measure of rik "standard deviation over a one year period is and should be irrelevant to most investors. Since the investor should have a long term focus why should the one year fluctuations of an investment be an important input to their discussion (also long term investments dont fit a bell curve distribution...but that is another more academic discussion.

Loss Aversion does have another nuance: past outcomes influence current decisions.

House money effect: Investors tend to take more risks when playing with "house money" i.e. gambling with profits. Rationally the decision to invest aggressively/take more risk simply because there are already profits in the account is irrational there should be no difference where the new investment money comes from. But investors don't behave that way. That likely explains bubbles and momentum in markets.

By the way it  could explain why Thaler has stated that he is concerned about current market levels its continual rise  with low volatility yet markets go higher and it seems investors continue adding to their stock allocation.

Break Even effect: Investors are prone to take more risks when presented with the possibility to make back the money lost.

All of the above factors should not influence investor behavior if they were rational decision makers the "homer economicus" of classical economics...but they do.

Furthermore all of the above factors work against the investor making the proper allocation policy: rebalancing by selling some of their winning positions and buying more of the losers. Everything described above moves investors to buy high and sell low.

Smart Beta, Thaler, and Your Portfolio:

"Smart Beta" is a hot term in finance although many of these factors have been known for quite awhile and have been available to investors through passive vehicles

The value factor:

 Data shows that over the long run value and particularly small cap value stocks outperform the overall market. The explanation for this is likely at least in part behavioral investors: overreact to losses and bad news which causes price declines and are drawn to stocks with recent high performance. and investors are drawn to "hot  stocks" that are in the news and have had recent large price gains --the exact opposite of  vale and small cap value stocksThis leaves "value" stocks based on measures like low price/book or p/e, particularly small cap value stocks   to have good long term performance...but likely periods of shorter term underperformance. Dimensionsal Fund Advisors was the first to offer passive/index vehicles weighted towards these factors. They are now available at very low cost through a number of value ETFs large cap and small cap using a variety of methodologies.

Momentum

Another factor that has been clear in market data has been momentum:,the tendency of markets and asset classes to perform in trends. This factor has long been used in "technical analysis" which academics have dismissed as voodoo for many years. More systematic research has indeed shown a momentum effect leading even the most  stubborn of "efficient markets" advocates Nobel Prize winner Eugene Fama to admit he couldn't find a rational(risk/reward based) explanation for this behavior. It would seem that the house money effect is at least one of the factors at work here. The behavioral explanation is clear investors extrapolate expectations of future performance from recent short term performance..which in turns adds to the "herd effect" in markets. As the market rises and the investors have gains in their portfolios they are more willing to take risks and purchase additional stocks..even riskier ones.

Momentum ETFs which purchase individual stocks based on their short term momentum and sell them when the momentum ends attempt to take advantage of this anomaly. Momentum factor ETFs are a more recent phenomenon and can be accessed with an ETF like MTUM which carries a management fee of .15% Momentum shows its best performance in strong up markets thus it is not surprising that momentum has not only outperformed a market cap weighting but also the other smart beta factors..over the past 3 years by a significant margin (total return of 66.5% vs. 44.5% for the cap weighted index).

Low/Minimum Volatility This strategy tilts towards stocks with low volatility. Because these stocks offer the prospect of smaller gains and smaller losses they are ignored by investors who are attracted to "lottery tickets": stocks with a low prospect of very high returns despite the fact they also have a much higher likelihood of losses. This the effect caused by investors trying to "make back" their losses.
 In other words the higher expected return of the low volatility portfolio (high likelihood of small losses and small gains) is rejected in favor of the higher risk portfolio with a lower expected return but a perceived higher potential of a "big gain" to make back losses. This low/minimum volatility strategy can also be incorporated through low cost ETFs. This strategy has shown long term outperformance by showing smaller losses relative to a market cap weighted index during market downturns while underperforming in strong up markets. It represents a "free lunch" that efficient markets theorists say cannot exist: higher returns without an increase in risk.

If in the past the work of Nobel Prize winners seemed esoteric with little relationship to real world decisions we all make this is clearly not the case with regards to Thaler's work. This time around with academic work that doesnt include books full of equations the Nobel Prize winning work is accessible to all. Reading Thaler' very readable accessible and entertaining book Misbehaving is highy recommended...a rational choice of reading material.

One last anecdote: when asked how he would spend his Nobel prize money Thaler replied "as irrationally as possible".

Third Quarter 2017 Market Review

Equities around the world had a strong quarter with non- US stocks outperforming those in the US.

 US stocks were up 4.5%. Among” smart beta” factor ETFs momentum had a very strong outperformance while minimum volatility underperformed.an outcome to be expected in strong up markets (details in table below).

Once again led by the FAANG stocks Facebook, Apple, Amazon, Netflx and Google which together make up not only 10% of the S+P 500 but a very high weighting in many actively managed mutual funds (Netflix has a small weighting in the S+P 500.

Except for Apple, the above noted stocks that dominate the market weighting trade at high valuations. Amazon trades at a price earnings ratio of 195 –the company plows all its cash flow from businesses back into business development. Therefore showing high revenues can capital investment but low profits.  Facebook with a  p/e of 38 and Google trades at p/e of 34.5 are well above the market p/e..which itself is historically high (see below)

Depending how one looks at these stocks : Amazon on its way to dominance in just about everything and Facebook and Google now replacing broadcast television and other media as the primary destination for advertising the valuations are either justified or the companies are reaching the law of large numbers and simply can’t grow enough to justify their valuations.  Apple which I would view as most vulnerable to challenges trades well below the overall market valuation with a p/e of 14.5.

The top performing sector for the quarter was technology (ETF XLK) up 8.4% nearly twice that of the overall market.

The major concern voiced by market observers are the historically high valuations of the US market (which is partly a product of the stocks mentioned above). As can be seen from the chart below we are at relatively high historical valuations. It must be noted that this concern that this has been the case for several years as the stock market continued to rally. Those that have timed to market because of valuations have missed out on the market gains.

S&P 500 Price Earnings Ratio Current 25.18 Long Term Mean 15.67

Part of the underpinning for the market rally has been better economic conditions and growth in corporate profits which seems likely to continue. Of course, the strong rise becomes self-reinforcing due to the well-known momentum behavior of investors.

  Also supporting the equity market was the low interest rate policy of the Federal Reserve since 2008. That easing cycle has ended with a gradual increase in interest rates. This has begun to remove one of the factors making investors feel they had “nowhere else to put their money” in a world of near zero interest rates. This movement away from seeing stocks primarily as a “bond replacement” can be seen in the recent underperformance of dividend weighted ETFs as well as REITS.

One widely observed measure of the attractiveness of stocks vs bonds is comparing the dividend yield of stocks vs. bonds. As can be seen from the chart below recent rises in stocks have tilted the measure in favor of stocks. Further increases in rates will accelerate this trend.

While high valuations and higher interest rates should be a drag on US equities but likely not enough to spark a sharp drop and for the nearer term positive although lower returns than we have seen as late. This would be due to the positive fundamentals: low inflation, good economic growth and continued positive trends in earnings.

 Combining market cap weighting with “smart beta” holdings in small value and minimum volatility should shield portfolios a bit from any market declines.

US Equities		3 Q	1 yr.	3yr
VTI	US total Stock Market	4.5%	19.6%	35.7%
PRF	US Fundamental Large/Mid Cap	4.2%	17.9%	29.7%
VBR	Small Cap Value	4.5%	18.7%	37.2%
MTUM	US Momentum	7.9%	25.8%	53.2%
USMV	US Minimum Volatility	3.3%	13.6%	42.2%

Non- US Equities have outperformed the US of late with European equities hitting record highs and emerging markets showing their best performance since 1979.

European economies across the board have been improving and markets have already factored in the impact of Brexit for the Eurozone –and even for the UK which shows strong performance although well below the Eurozone. Unlike the US the European central bank has given little indication of moving to raise rates. Lower valuations, underweighting of many portfolios to non- US stocks, and a positive interest rate environment make for a benign environment for European stocks possibly continuing their outperformance vs. the US.

 A tilt towards the core Eurozone countries and specifically Germany has continued to be a more profitable strategy vs. an allocation to the overall developed market which includes the UK and the perennial laggard Japan. This reinforces an argument I have made about both the developed market asset class which includes the diverse markets of Europe and Japan in a single index.

Emerging Markets have continued to show extremely strong performance based on a benign political and economic environment. China’s growth remains strong as does that of the export oriented countries in the rest of Asia. Tensions with North Korea and the risk of economic crisis in China are always potential negatives for the Asian markets but the latter would likely impact markets around the world as well. While overall emerging markets which include Latin America and Russia the Asia only emerging markets have shown better performance illustrating here too that the asset class of emerging markets including Asia, Latin American and Russia is not particularly useful way to allocate portfolios.

Looking forward strong fundamentals remain in emerging markets, Institutional investors as well as individuals are underweighted in these markets factors likely to generate more buying.  Emerging markets always have “hot money” flows which chase performance which would drive performance in the short run. But investors in the long term are better off sticking to their allocation in emerging markets rather than chasing performance.

A performance chaser in emerging markets would have likely wound up selling at extreme lows and buying well after market recoveries begun. Emerging markets are only for those with a strong stomach and a commitment to keep to their allocations.

Active Fund Managers :Stock Pickers or Part of the "Mob" ?

One of the greatest cliches heard in the financial markets from active managers is that the market is in a "stock pickers market". With the growth of ETFs their new argument goes, investors are mindlessly buying stocks in an index while stock pickers can find undiscovered gems.

But the evidence shows quite the opposite. Active managers are more part of a performance chasing mob than individual investors in ETFs. The big outperformers this year have been the "FANG" (more correctly (FAANG)stocks: Facebook, Amazon,Apple,Netflix and Google (alphabet).

As noted in this analysis active fund managers have large overweights in the FANG stocks even though they reduced them as of this September 6 report>

Fund managers are no longer as smitten by the FANG stocks as they used to be even as they continue to pile into technology stocks for the seventh consecutive month, according to a research note from Bank of America Merrill Lynch (BAML). Large cap fund managers now have a record overweight(vs the S+P 500) in the sector but are opting to rotate out of the FANGs

Alphabet Inc

GOOGL

973.72

+0.92%

in favor of less crowded stocks.

This year, the FANGs' stock performance has far outpaced the S&P 500 Index. Now, it seems that fund managers are starting to conclude the FANGs' biggest gains are over. Look at these numbers. Fund managers’ overweight position in FANG stocks has dropped from 71% to 64%, 

And where did those managers mover their money that left the FANG stocks ? into another hot sector.:

 their overweight positions in tech, internet retail and other non-Fang stocks has jumped from 16% to 22%, according to BAML.

Which investors are actually taking too much risk by concentrating in tech and FANG? those active managers..or the investors in the largest ETF SPY=the S+P 500. Of course the FANG and technology stocks can't be "overweighted" vs the index...they are the index.

Netflix makes up less than 1% of the SP 500 but apple, amazon, facebook, and google make up a combined 10% certainly a high amount...now consider that active managers are 60% overweighted .All of those stocks except Apple carry high valuations far higher than the S+P 500. Amazon which plows most of its money back into investments has a p/e measured at an astronomical p/e based on actual earnings of 2016 of 195.

 Add to that the fact that they have moved their sales of those stocks into technology many of those high flyers of late and it is hard to see how the active managers have done stock picking by "going against the crowd".

If the growth of indexing has created opportunities for stock pickers..it doesn't seem like those stock picking active managers are doing much research..they are just following the herd and buying what is going up...not searching for undiscovered gems.


Investors a who included "smart beta" strategies such as momentum and small value in their  ETF (which carry fees a fraction of those even on the lease expensive active funds) portfolios would have  lower weight for the fang stocks than the active managers and the sp 500. Interesting the Momentum ETF (MTUM) includes only one of the Fang stocks among its top ten holdings--the one with the lowest p/e of the group..Apple. And of course small value ETFs like VBR don't hold any of those stocks at all.

So which investors are blindly chasing stocks because of recent performance: the active fund manager or the investor who holds the SP 500 or ETF r an ETF portfolio that includes some "smart beta "holdings ?

Confused ?

I see things like this all the time but I cant recall the same publication contradict itself this way within three business days

WSJ September 29

Dow Deja Vu: ‘Trump Trade’ Regains Favor

Investors betting the Fed will raise rates and Republicans will make headway on tax overhaul

WSJ October 2

Two Signs the ‘Trump Trade’ Isn’t Really Back

WSJ October 3:

The Most Important—And Least Understood—Thing in the Market: Taxes 

....The White House tax plan is the big opportunity for investors right now, and many see the risks only about whether it will happen and how big it will be, not in how it will affect the market. It just seems obvious that tax cuts will produce effects similar to the “Trump trade” that gripped the markets after Donald Trump’s election last year. Stocks will rise, led by banks, smaller companies, high-tax companies and economically sensitive cyclical stocks. Bond yields and the dollar will go up, and emerging markets will underperform.
The trouble for investors is that exactly this has already been happening in recent weeks. If it was all about taxes, these market trends would suggest there has been a huge reassessment of the prospects of the plan passing Congress.

I am Trying to Figure Out Why This Would Draw Investors Back into Hedge Funds

Apparently hope springs eternal and the industry is a genius at marketing because I cant understand the following :

from the WSJ

Hedge Funds Ain’t Dead Yet

With an improved environment for stock picking, the average hedge fund is up an average 5.4% through August

Written off less than a year ago as overpriced and underperforming, hedge funds are pulling off an unexpected two-step this year: Making money and taking in new cash.
The average hedge fund is up 5.4% through the end of August, while stock-focused hedge funds have gained 8.31%, according to the researcher HFR. Over the same period, the Standard & Poor’s 500 rose 11.9% including dividends, while the traditional 60-40 split of stocks and bonds would have earned 8.9%.
That makes this year the industry’s best relative performance in a rising market since 2010. Investors, particularly in Asia and the Middle East, have begun sending new money hedge funds’ way, attracted by the better returns and a broad lowering of the industry’s famously hefty fees.

So a middling performance using what is by a riskier strategy and more expensive investment vehicle than a simple index fund attracts investors...color me confused

One example that investors in hedge funds could find themselves a part of is described in the article

One of the biggest rebounds is under way at Brahman Capital Corp., a New York hedge-fund firm that flew under the radar for more than three decades.
At its apex around two years ago, Brahman managed more than $5 billion, as principals Mitchell Kuflik and Robert Sobel bet big on hedge-fund favorite Valeant Pharmaceuticals International Inc. When Valeant’s stock plummeted from $257 to $14 a share, Brahman fell in turn, as the firm reported losses and investors pulled their money.
Brahman sold Valeant stock last year and with what is now $3.8 billion of remaining cash pivoted to new ideas like a stake in travel company Expedia , people close to the firm said. This year, Brahman’s main fund is up 17%, the people said

With the availability of so many low cost ETFs both capitalization and weighted systematically towards factors that have been found to potentially add to returns it is hard to justify the use of hedge funds even at fees reduced from the old style "2 and 20".

As for the claim of a better environment for stock picking I cant remember a time when I haven't heard that one and not seen results that justify the claim.