The “Secret” Morningstar

I love Morningstar. It is my primary research source. I enjoy the posts of their columnists. But unlike most investors who use Morningstar, I basically ignore their legendary “star” system. Morningstar itself has told investors that their star system is not intended to be used for predictions of future performance. Various studies  have examined the sustainability of a mutual fund’s “stars” rating and found an overall pattern of lack of sustainability.

No, I love the “secret” side of Morningstar, the wealth of valuable information that allows me to evaluate other aspects of a fund, factors that have been shown to provide a meaningful evaluation of a fund’s value. Financial publications like to publish “best of” or “top” list at the end of one year or the beginning of a new year. In most cases, the lists are based on a fund’s nominal, or simple/stated, returns.

The problem with nominal returns is they can often be misleading. For example, actively managed funds often impose a front-end load, or sales charge. The front-end load is immediately deducted every time an investor invests in the fund. The maximum front-end load currently allowed by law is 5.75 percent. That means if you purchase $100,000 of a fund, the amount you will have to invest will only be $94,250.

As a result, the investor who invests in a fund that charges a front-end load will always lag the performance of an investor who purchases a no-load fund, assuming similar performance between the two funds. The odds of similar returns is increasing as many actively managed funds are posting high R-squared, or correlation of returns, numbers.

Funds that essentially track comparable market indices and/or comparable index funds, are referred to as “closet index” funds or “index huggers.” The problem with closet indexing is that investors usually obtain the same, in many cases lower, returns that they could have obtained on a no-load fund, but at a significantly high cost. That is why funds are legally required to provide investors with their load adjusted returns. The impact of front-end loads reducing investor returns even worse over time due to the impact of annual compounding.

Investors should also compare funds’ risk-adjusted returns. A basic principle is that investment returns are a function of risk assumed. Funds are not legally required to publish their risk-adjusted returns, and there are many methods used to calculate risk-adjusted returns. Many investors are unaware that Morningstar publishes a statistic that incorporates both a fund’s risk-related return and tax-efficiency score. It is available under the “Tax” tab on a fund’s Morningstar main page.

“Secret” Morningstar also provides me with valuable information that I use in evaluating a fund’s cost-efficiency. While mutual funds proclaiming to be #1 in performance are common, how many investors have ever seen a mutual fund ad claiming to be #1 in cost-efficiency. Don’t expect to see one anytime soon, as studies have shown that very few actively managed funds are even close to being cost-efficient. In fact, studies consistently find that very few actively managed mutual funds even manage to cover their costs.

As a securities/ERISA attorney, I rely on the Restatement (Third) Trusts for the applicable standards to determine applicable legal compliance for investment fiduciaries, specifically Section 90, otherwise known as the Prudent Investor Rule (PIR). Three key provisions of the PIR are:

  • comment b, which states that fiduciaries must be cost conscious,
  • comment f, which states that fiduciaries must seek either the highest return for a given level of cost and risk, or conversely, the lowest level of cost and risk for a given level of return, and
  • comment h(2), which states that an actively managed mutual funds that is not cost-efficient is an imprudent investment.

Re-read the last bullet point. Now combine that with the previous note that studies have consistently shown that very few actively managed mutual funds are cost-efficient. Funds that are not cost-efficient means that investors effectively suffer a new investment loss. Now take that information and review those “best of” and “top” articles again.

Far too many investors lose money unnecessarily by only evaluating funds based on their nominal, or stated, returns. I refer to my law practice as focusing on wealth preservation. As well-known Scottish proverb states

make as much money as you can, and keep as much as you can. That’s the secret of getting rich.

That is why I created the Actively Managed Value Ratio™ (AMVR). The AMVR is free on various parts of this site and allows investors, investment fiduciaries and attorneys to quickly evaluate the cost-efficiency of an actively managed mutual fund using the same “secret” Morningstar data that I use in my law practice. In other words, the AMVR can help you maximize your investment returns and protect that wealth.

Gura math a theid leat! (“Good luck”)

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