Beware Morningstar Myths

Beware Morningstar myths. Specifically, I want investors to understand that while Morningstar has provided the markets an amazing product and really in many ways revolutionized fund investing and fund research, the firm does have a few things you might want to know about. In fact, the Financial Times in an article on August 21st, 2014, Last year did a big exposé on how much money fund companies actually spend in order to make sure that their ratings are good. Bill Gross spent big bucks and a huge amount of his time to make sure his PIMCO bond fund did not blow up when one of his partners left. And after some of the statements he made turned out to not be so true. Right. Does it make sense that the owner of the fund or the manager of the fund should have an influence or even want to pay money to try to have influence if it didn't work, right? They're not spending a lot of money. A lot of times, you know, big millions of dollars, senior executives dedicated to doing nothing but making sure that that Morningstar analyst rating doesn't fall. That's not good. That's a conflict of interest in my opinion. In the same way, it's a conflict of interest when company executives have undue influence on Wall Street analysts when they're making recommendations for stocks. Not good. Another thing that we found, and there's a great study in this in our article, that found that people are so desperate to try and get money out of having the right Morningstar rating that they will often move their fund into another category where their relative ranking will be better so they can attract assets even though their performance is not any better. They make more money simply by changing the type of fund they are In order to get assets and their performance is as bad or worse. So it's just a way to trick people into giving them more money because they go to a category that doesn't have as many funds and therefore it doesn't have many funds, doesn't have many good funds or even medium funds and they're a mediocre fund but they go into that category, they attract assets, they make money, the performance isn't any better. We don't really want a system that incentivizes people changing the name of what they do and making more money from it when they're not actually making more money for shareholders. Fund managers shouldn't make more money if shareholders didn't make more money. That's a problem. And we think in general, you know, that investors need to keep in mind that, you know, while Morningstar covers a lot of things in their fund ratings, they don't cover what we think is one of the most important things, like the quality of the holdings. Our fund ratings due diligence on the quality of the holdings of all 7,000 and all 400 ETFs that we cover. And we think our ratings make a difference. For example, on— starting July 23rd, 2013, TFS Capital Investments Small Cap Fund, ticker TFSSX, got a 4-star rating from Morningstar. It got a very dangerous rating from us. Since then, we've outperformed by 25%, right? The fund is down 12%. Versus 13% for its benchmark, right? So if you paid attention to us, avoided the fund, we saved you 12%. Avoided that fund and just put your money in the benchmark, the Russell 2000, we saved you 25% if you followed that advice. On October 15th, 2013, the Icahn Materials Fund, ticker ICBAX, 4-star rating from Morningstar, very dangerous rating from us. Since then, our rating would have outperformed by 16%. You've gotten 5% performance out of the Icahn Materials Fund while the S&P was up 21%. Again, a spread of 16%. On January 22nd, 2014, iShares Dow Jones U.S. Medical Devices Index, IHI, got 1 star from Morningstar and it got an attractive rating from us. Since then, that fund is up 21% versus just 12% for the S&P, or 9% spread. We've got many more examples of ratings where we have provided investors an edge. And it's because we're doing diligence on really what drives performance, the individual companies. We'll go through and make sure that you know, if you want to, if you're interested in a fund, we'll tell you how many very dangerous stocks are in that fund and how much risk there is of being in that fund. We don't really feel like, and, you know, no surprise, there are a lot of disclaimers to this effect, that past performance should be a good indicator or a reliable indicator of future performance. In fact, the laws dictate you have to state that whenever you show performance metrics, right? Right. And yet, that's the primary, primary part of what goes into a Morningstar rating. And I think, look, to be candid here, it's a great service and it's been proven to be a great service for many for a long time. And part of the problem is that to actually do research on all the holdings on a mutual fund is an impossible task. If you've seen my other tutorials, especially about why data quality matters and return on invested capital, You know, it's an impossible task to do proper homework on even one company for most professionals. You know, maybe if you can live in your basement and do, you know, have nothing to do for 6 months, you got time to read 5 200-page annual reports. Otherwise, it's a really cumbersome task. We've created technology and scale around this expertise that we have here so we can cover a lot of annual reports. We'll do another tutorial on that another time. Trust me, FASB, And many other regulators rely, many, many top-tier hedge funds and many advisors and individual investors rely on us for the diligence we do. And then don't just take their word for it, take Barron's word for it, Wall Street Journal, MarketWatch, etc. The takeaway is we do the diligence on the holdings. We go through and analyze every one of the holdings in that fund so we can tell you if there's a blowup in there. Past price performance won't tell you that. In fact, the better the performance of the fund, Many times, more likely there's a blowup in there because blowups tend to happen in funds that are too expensive. So we're going to do that diligence and we're going to give you a rating on a fund based on the quality of the holdings, the quality of the cash flows, and the relative valuation of all the stocks held by that ETF or mutual fund. And another thing we're going to do that's really important is we're going to give you the all-in cost. We're going to give you one number that tells you the total annualized cost of being in that fund It takes into account front-end loads, sales charges, expense ratios, redemption fees, back-end loads, and trading costs or turnover. And what we find is that expense ratio is awfully— it can be an awfully misleading number. The actual real cost of being in that fund can be much higher. And it's funny, we've seen this in situations where we've seen 2 funds with exactly the same charter doing the same thing, and one will trade 300% of the other one. Guess how much trading costs the fund manager? Zero. Guess how much it costs you, Mr. Investor? Everything. You pay the trading costs. So why is he trading 300%? I don't know. Maybe his broker takes him to the chalet in Switzerland every year by throwing him so many commissions. Who knows? The point is you need to know about the trading costs. We incorporate that into the total annual cost metric that we create for funds. So you have— What's the total annual cost metric? Again, we like to call eyes wide open, the full diligence. So we're here to help, and all you got to do is take a look at the research and make a more informed decision. And we recommend that you take a look at all— we have 10 other funds that actually currently right now have a big difference between our rating and Mutual Fund— and Morningstar's rating. And if you click here, you get access and can see the rest of those and make sure that you don't step in those landmines. Thanks, David.