Fund ratings giant Morningstar recently released its quarterly list of fund analyst picks, and the results are disturbing.
When it comes to picking domestic stock funds, Morningstar’s analysts – professionals armed with boatloads of data and all-access passes to fund managers – actually do worse than the average investor casually picking index funds, and they seem to do no better in some fund categories than the same investor throwing darts. The implications for casual individual investors are startling.
Last quarter, we noted that their “batting average” was only slightly better than your standard dart-thrower and worse than buying index funds, but when their picks are parsed into different fund groupings, the numbers are surprisingly poor, and highlight how difficult fund picking can be, even for the experts
"...our five-year average was 65%. That means that our picks have been winners about two thirds of the time over the past three and five-year periods. We think that's solid."
As we’ve noted before, index funds generally beat their fund category average over 65% of the time. But even this measure of success belies the trouble picking funds in the key area of domestic stock funds – which is where most investors maintain the bulk of their fund holdings. Morningstar now sheds a little light on this issue:
"It's interesting to note that by asset class, the weighted batting averages show our picks have been more successful in foreign stocks, municipal bonds, and taxable bonds, and less so with domestic equity. For example, 98% of our foreign large-blend picks have been winners over the past five years, while just 50% of our domestic large-blend picks have been winners."
50% is pathetic. Any dart-thrower could expect to beat the large-blend fund category average (not the benchmark index) at least 50% of the time (half would beat, half would lose).
Morningstar does not detail their performance in other domestic stock fund categories like small-cap and mid-cap value, growth, and blend. They do state the following, however:
"Using the aggregate measure, our domestic-equity picks (excluding sector funds) returned 9.56% versus 7.76% for the Wilshire 5000 and 6.27% for the S&P 500. We're pleased with those figures, too, but recognize that market-cap bias has a hand in that success."
Market-cap bias had more than a hand in it. Fund investors may not realize just how badly large-cap growth funds have performed in comparison to other fund categories in recent years.
At the end of the first quarter of 2007, looking at the past five years (2002-2007), the ONLY fund category that underperformed the S&P 500 was large-cap growth (ironically, this is the fund category where most domestic five-star funds could be found back in 2000 before Morningstar adjusted their ratings system to look at performance in category as opposed to performance against all domestic stock funds). The large-cap blend funds' performance nearly tied with the S&P 500 in a dead heat. In other words, the dartboard fund pick from each domestic fund category (there are nine) had a 77% chance of beating the S&P 500. Five out of nine domestic stock fund categories beat the market cap-weighted Wilshire 5000. If you'd matched the domestic stock fund category averages over the past five years, you'd have beaten the Wilshire 5000.
Sometimes it's very easy to pick winners in a certain category. Bond-fund picking is all about expense ratio. There are scores of bond funds out there with total expense ratios (including 12b-1 fees) over 1%. How in the world are these funds going to perform well with bond yields around 5%? As Morningstar notes,
"In bondland, we've enjoyed a lot of success in core categories such as intermediate bond and muni national long where our batting averages are more than 90%."
As the performance of large-cap stocks improves, it will become even more difficult for fund picks to beat benchmark indexes. The typical stock fund has an average market cap lower than a market cap-weighted benchmark index.
Bottom line - picking winning funds is at best difficult, and often a total crapshoot. Many investors and even Morningstar analysts are too easily swayed by good past performance. They ignore or downplay expenses, fund asset size, reversion to the mean, and plain old luck. The vast majority of investors (and those that choose funds for 401(k) plans) should just go with index funds – if they do, they’ll probably beat Morningstar's analysts.
