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Morningstar Picks – No Better Than Dartboard?

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.

MAXadvisor Powerfund Portolios Update

Note to subscribers of the MAXadvisor Powerfund Portfolios: this month's portfolio performance data update and commentary has been posted. Subscribers can log in by clicking here.

The MAXadvisor Powerfund Portfolios is a collection of seven model mutual fund portfolios ranging in risk from very safe to quite aggressive. Each portfolio is made up of a group of terrific, no-load, low-cost mutual funds that are carefully chosen to work together to lower volatility and increase returns. You can learn more about the MAXadvisor Powerfund Portfolios (and sign up for a free trial if you like what you see) by clicking here.

April 2007 performance review

April was almost shockingly strong for stocks. The S&P 500 jumped 4.42%, the Nasdaq 4.27%, and the Dow a whopping 5.87%. International stocks climbed just shy of 4%. Yet, the strength was mostly in larger cap stocks. The Russell 2000 small cap index was up just 1.8% in April, and has scored only a 7.83% gain over the last 12 months—a time period during which the S&P 500 climbed more than 15% and the Dow 17.6%.

Green Stocks Too Hot?

Marketwatch reports that so-called "green" stocks, the underlying investments of environmentally-focused socially responsible funds, could be heading into speculative bubble territory.

'It was just a year ago where we would have somebody arguing with us over whether or not the market would ever favor green investing,' says Jack Robinson, co-manager with Matt Patsky of the Winslow Green Growth Fund. "What a difference a year makes.'

Indeed, some green fund managers now see the share prices of many companies tied to environmental sustainability as, well, unsustainable. 'Now you've got to worry about valuation and some of the speculative bubbles that are building,' Robinson says.

'I'm certainly concerned that you have too much hot money moving in,' says Eric Becker, co-manager of the Green Century Balanced Fund , which keeps about two-thirds of its portfolio in stocks and the rest in bonds. 'There are investors who are going to get burned.'"

We feel investor exuberance (and lack thereof) is a key factor in investing decisions. There are many ways to keep tabs on how overblown an investing idea is. Initial public offering volume and excitement is one indicator, as is rising prices and investor enthusiasm.

However, just because a few stocks go public and a few others rise does not mean the party is over. We consider fund investor behavior to be a little more indicative of bubbles and future bad performance than hot stock performance in an area. On each fund data page on MAXfunds.com, you will see our “Hot Money Index” which measures how much money is flooding into a fund. We also measure hot money across all funds in a fund category.

You'll note that many of these green funds do not have much hot money, meaning they are not bringing in the hundreds of millions (and sometimes billions) of new cash we often see before an area stalls or worse, crashes. But before jumping to the conclusion that this means there is much more upside here, be aware that most of this sort of “trendy” money these days goes into ETFs, not old fashioned open end funds.

While the typical fund investor hasn’t put many chips on the alternative energy table in open end funds in the last year, ETFs have had more success. We now have new ETFs like PowerShares WilderHill Progressive Energy (PUW) and PowerShares Wilder Clean Energy Portfolio (PBW). The later is tipping the scales at around a billion dollars, pretty big money for a gimmicky new fund. New fund launches are another negative sign – fund companies tend to launch new funds near the top not near the bottom of any cycle. PBW has brought in more than ten times what the newest open end alternative energy fund has brought in – Guinness Atkinson Alternative Energy (GAAEX) - even though this open end fund has performed better than the ETF.

Bottom line, if you look just at open end funds, we have more to go in this speculative area. When you bring in ETFs, we look a lot closer to the top in alternative energy stocks.

Green funds mentioned in the article:

Winslow Green Growth Fd (WGGFX)

Portfolio 21 Fund (PORTX)

Sierra Club Stock Fund Inv (SCFSX)

Green Century Balanced (GCBLX)

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