In Animal Farm, George Orwell describes a Utopian society that slowly morphs into the evil farm that its founders initially rose up against. The Motley Fool’s latest advertisement, touting "255% Gains in Six Months," is perhaps their "four legs good, two legs better" moment.

This pattern of closing mutual funds that fall on hard times in order to focus on the good stuff looks strangely familiar. That's because it's the same strategy used by the very mutual funds that the Motley Fool used to ridicule. With mutual funds, this cleansing process is called survivorship bias. This trick-of-the-trade is why many fund companies appear to hold only decent funds in their roster. The Merrill Lynch Internet Strategies Funds of the world are effectively deleted from history.

One thing the Motley Fool does today that mutual funds are not allowed to do is cherry pick performance information in order to market their wares. Of course, the Motley Fool is not alone here. Virtually all investment newsletters tout their spectacular returns through methodologies that would make a mutual fund marketer blush. But because everybody is doing it, selling an investment newsletter without such circus barker-grade promotion is nearly impossible... ...read the rest of this article»

Normally when you hear the Department of Defense is presenting Congress with a report on their progress, a highly politicized debate over Iraq comes to mind. This time the report deals with protecting soldiers not from IUDs but RIAs (registered investment advisors), brokers, and insurance salesmen.

Working in the military can be a tough job with not much in the way of financial reward. This is why unscrupulous insurance and investment salesmen deserve the new military surge against dangerous investment advice targeting enlisted men and women:

The crackdown stops certain questionable sales practices:

We like the Personal Commercial Solicitation Report, which "lists insurance and financial product companies and agents currently barred from soliciting on specific DoD installations as reported by the military services."

The report contains such gems as, "Agent barred for loitering near enlisted quarters; falsely inferring command endorsement; and attempting to discourage a military member from reporting him for soliciting on-duty personnel and soliciting personnel in a mass audience."

Apparently some war profiteers hock financial peace of mind…

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Barron's online did a comprehensive review of Jim Cramer's Mad Money stock picks, and the results are unsurprisingly mediocre:

We'd normally advise people to go ahead an watch CNBC's Mad Money because of its entertainment value, but Cramer is so good at making his picks sound like can't miss investments opportunities that even I've occasionally been tempted to fire up E*Trade and dive in. Mad Money no longer sullies my TiVo. I watch Jeopardy instead.

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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.

A new ruling by the U.S. Court of Appeals in D.C. means that brokers will now be subject to the same regulatory standards as investment advisors. Previously brokers could sell you whatever crappy investment that made them the biggest commission and only pretend to have your best interests at heart, and then not get sued when those investments lost you a bundle:

No, you can't. That's why the founders of MAXfunds.com manage money as commission-free investment advisors, not as brokers.

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