Integrated Financial Education: Westchester NY

Using the Morningstar Fund Screener

I'm not going to pay a lot for this muffler!

There is a difference between being miserly and being frugal. Being miserly means hoarding wealth out of greed. Greed, as we saw in other articles is a source of misery that actually leads to loss of wealth. Being frugal mean properly preserving your scarce resources, which can lead to happiness. Here we approach the topic from the standpoint of being frugal.

So what is a quick and easy way to pick a mutual fund? First we want to do a cost/benefit analysis. What are we getting and how much are we paying for it. When we approach this subject, healthy skepticism is in order. The majority of mutual funds have difficulty outperforming their benchmarks. If they don't outperform their index, we can simply purchase the index instead. If one does outperform their index, the next question is whether it was due to luck or skill. Do they actually have an investment process that is likely to produce somewhat higher returns than the averages over a long period of time? If the benchmark is an average performance, then one would expect roughly half of the funds to outperform and half to underperform during any given period of time. Is it the same funds that outperform, meaning if we purchase one that has outperformed in the past is it more likely to underperform when we purchase it?

These are questions that should be answered. For example, the American Century Growth Fund (symbol: agwrx)is an actively managed fund that charges 1.47% fees on an annual basis. They invest in large cap growth stocks indexed to the Russel 1,000 Growth index. Ishares has a passively managed index fund (symbol: iwf) that charges 0.20% on an annual basis. If they both received the same fees before deducting expenses, after 40 years invested you would have $1.63 in iwf vs $1 in agwrx. This is a huge difference in wealth.

There are two methods to determine whether a fund is likely to outperform its benchmark persistently: qualitative and quantitative means. We will start with qualitative, which answers the question why one would expect the fund to outperform. The quantitative method answers the question did they outperform in the past in such a way as it supports their potential to do so in the future. An example might be that they invest in less liquid securities, which historically have been shown to outperform due to the liquidity premium they require. For the qualitative analysis, we need to rely upon Morningstar's Premium service. For the quantitative analysis we will use their free service.

Morningstar's fund analysis discusses the investment process used by agwrx. They explain that the fund tries to match the Russel 1,000 Growth Index by sector as well as various factors such as volatility or momentum. Their focus is almost entirely individual security selection. So the question here is whether these guys are such great stock pickers that they can overcome 1.27% management fee differential plus heavy taxes from turning over their portfolio say 80-100% as they did in the past two years. There isn't a discussion of why their stock picking prowess is expected to be so good.

The quantitative analysis also does not seem to support the idea either. There are a few tabs in Morningstar's free service that are very helpful. Start with the Ratings & Risk tab: you find their best fit index is the Russell 1,000 Growth Index with an R-squared statistic of 99.06. This statistic measures the degree to which the index explains the performance of the fund - 100 is 100%. It basically means this index is an excellent representation of the fund. For the short version of how to screen a fund, this is sufficient, but more information is available on the Portfolio tab if you are interested.

You must find the correct index first, and it is not necessarily the index the fund itself promotes. If the fund invests in high risk and high return stocks and I use a low risk and low return stock index, the fund will easily beat the index. The problem is that I will actually be taking more risk in the fund. Also, the actual alternative for me to invest in is the correct index not the lower risk one.

Next we go straight to Performance. We will look at this tab for both agwrx and ifw and compare their returns for the past 5 years:

These returns are after the management fees are deducted. They do not show a persistent outperformance of the fund versus an ETF you can easily purchase as a substitute. The fund outperformed by more than 1% in 3 of the past 10 years and underperformed by more than 1% in 5 of the past 10 years. Ultimately if you take the average for 10 years the fund underperformed slightly. But they underperformed by 1.27% in 5 years, which is precisely what would be predicted by the difference in fees. Institutional investors tend to determine whether or not to stick with a fund with 5 year's of performance and this fund may not have made the cut. Most of the underperformance was offset by the return in 2007 which was 6.81% higher than the iwf. Lastly check the Quote tab to check on taxable distributions. At the bottom of the page agwrx showed distributions of roughly 3-4% of the portfolio value while iwf had zero. Obviously if the fund is held in an IRA these are irrelvant. While statistical analysis based upon 10 years of data are very dicey at best, just a common sense inspection of this data suggests there is little persistence in the ability of agwrx to outperform.

If you have the time to search for funds, you might use the Morningstar Fund Screener, a premium service. Choose an index with the Best Fit Index Data such as the Russell 1,000 Growth Index. While you can choose from extensive criteria, you can simply run the screen as is and view the performance. You will see a 5 year return history and you can sort for the highest returns. If you do, you will find agwrx somewhere in the middle of the batch. You might note the range of 5 years returns is 13.49% to -4.19% during this period. Agwrx was 3.62%. You can dig through the higher returning funds to see if there is a reason to expect their returns to persist. Alternatively, you can ask a broker to select funds for you. However, I am sure many brokers sell agwrx, so you need to be sure that you are going to get the performance you will certainly be paying for if you work with an advisor who sells funds. Lastly, you can simply buy index funds that have low fees and are passively managed. But you will probably be better served by making sure your overall asset allocation is designed to meet your retirement income needs. Why and how to perform this task is discussed elsewhere.

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