Don’t Let the Stars Get In Your Eyes!

April 09, 2007

I own last year’s top performing funds. Unfortunately, I bought them this year. ---Anonymous

I own last year's top performing funds. Unfortunately, I bought them this year.

                            -Anonymous

Before deciding on which film to see, much of the movie-going public will read the reviews of the critics. Perhaps before even bothering to read the review, they will check to see how many stars the film was given by the critic. Just as the public relies on star ratings to decide which films to see, one of the most common investment strategies employed by individual investors is to buy the mutual funds that are given the coveted five-star rating by Morningstar. And it would seem that the best way to benefit from the due diligence and fund research performed by Morningstar's staff would be to simply replicate one of the three portfolios that Morningstar's FundInvestor publication recommends.

Since the Morningstar FundInvestor regularly publishes the performance results of its three portfolios, as well as the results of the index-based benchmarks Morningstar itself established, we can test the aforementioned hypothesis. This would also seem to be a good way to test whether trying to choose actively-managed mutual funds is a prudent strategy for the individual investor.

Let's examine the data.

The February 2007 edition of the Morningstar FundInvestor reported that, from its inception in November 2001, the Aggressive Wealth Maker portfolio returned 9.5 percent per annum. Unfortunately, its benchmark, which consists of 70 percent Vanguard Total Stock Market Index, 15 percent Vanguard Total Bond Market Index, and 15 percent Vanguard Total International Stock Market Index, returned 10.1 percent per annum. Thus, the active managers subtracted 0.6 percent per annum of value.

From its inception in November 2001, the Wealth Maker portfolio returned 7.9 percent per annum. Unfortunately, its benchmark, which consists of 55 percent Vanguard Total Stock Market Index, 35 percent Vanguard Total Bond Market Index, and 10 percent Vanguard Total International Stock Market Index, returned 8.7 percent per annum. Thus, the active managers subtracted 0.8 percent per annum of value.

From its inception in May 2002, the Wealth Keeper portfolio returned 6.9 percent per annum. Unfortunately, its benchmark, which consists of 30 percent Vanguard Total Stock Market Index, 65 percent Vanguard Total Bond Market Index, and 5 percent Vanguard Total International Stock Market Index returned 7.0 percent per annum. Thus, the active managers subtracted 0.1 percent per annum of value.

In all three cases, the efforts of both Morningstar's staff and the active managers themselves proved counterproductive. A logical question then is: If Morningstar, with all of its resources, fails to deliver value added, why should individual investors, with fewer resources, believe they are likely to succeed? While it is easy to identify after-the-fact actively-managed funds that have outperformed, trying to do so before-the-fact seems to be a triumph of hope (and hype) over the wisdom provided by decades of experience that has demonstrated that, while it is possible to outperform the market, the odds of doing so are so poor that the prudent strategy is not to try.

The Moral of the Tale

The moral of the tale is that instead of playing the loser's game of trying to beat the market by investing in past outperformers (you can only buy tomorrow's returns), the winning strategy-the one most likely to enable you to achieve your goals-is to simply accept market returns by investing in a globally diversified portfolio of passively managed funds that reflects your unique ability, willingness, and need to take risk. And that is what Morningstar's benchmarks do. Morningstar should have stopped right there, using the benchmarks as the recommended portfolios. Had they done so, they would have saved themselves and investors lots of both time and money!

Source: Morningstar FundInvestor (February 2007).

 

 

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