How to Invest in the Best ETFs and Mutual Funds

Hello everyone, welcome to our Thursday afternoon webinar right before 4th of July. God bless you guys who are here with us today and not already on vacation because we're going to provide some very interesting information regarding mutual funds and ETFs and how our coverage provides you more protection than the coverage that you see traditionally from mutual fund— other traditional mutual fund providers and their research. First thing I want to point out is really, you know, so much of the way that people think about research comes from Morningstar. And, you know, I think that there are some major flaws in the the Morningstar business model that people are not familiar with. Before I'm going to go into— before I go into that, I want to make sure I provide a couple of announcements though. All right, today we released, or at least earlier this week, we released our, our most attractive and most dangerous stocks for July. So that's out for clients to get access to that. Again, you get 20 large-cap and 20 small-cap stocks on the most attractive side, and there's another report where you get 20 large-cap and 20 small-caps on the most dangerous side. And I also want to highlight, you know, it's the fact that a lot of our research here, stock picks, um, have been highlighted in both Barron's and SumZero. Our article on Groupon was highlighted in SumZero, which is a hedge fund managers-only research platform, right? So I manage a hedge fund, and so I'm a part of that platform, and they only take top-tier research. They don't take anything from sell-side people. Anyone, anyone know why they don't take research from sell-side research firms? Any guesses? Because sell-side people are compromised and biased. We also did some recently, some really good work on business development companies. We've identified some key metrics that nobody else talks about in their research that you need to make sure you understand and follow in order to avoid getting blown up in a BDC or a business development company. We provide those stats in our special report. Under the special offers section of our site. Here is the hidden risk in business development companies, and then also we did a, a really in-depth piece of work on goodwill and how that can be a red flag, how you can identify which companies may be blowing up because of too much goodwill, too much acquisitions, companies that are going to be experiencing write-downs or be forced to impair assets in the not-too-distant future. These are, these are kinds of companies that you really got to be careful about owning toward the end of a bull market, because when the bull market ends, they're the ones that are going to get crushed the most. But circling back on bias, there's a lot of bias in fund research. Morningstar, not the least of it. We did this great article in August last year, Why Investors Need Independent Research, right? And the big thing that most people don't understand is that Morningstar is not unbiased. The Financial Times did an excellent article pointing out how the firm's rating system gives it great power to influence the $30 trillion mutual fund industry. Mr. Gross— this is when he was at PIMCO, right?— spent a ton of his time with Morningstar in order to make sure that they did not change his rating. Right. And he spent a lot of time schmoozing them because he realizes one small change in their rating and the amount of outflows from his fund would be huge. They have the power to move money, right? And so people like Bill Gross and his firm spent a lot of money convincing Morningstar not to change their rating. So it's biased. in that sense. It can be influenced in the same way that Wall Street is influenced by the people that spend a lot of money with them and people spend a lot of money influencing— trying to influence Wall Street. They have big investor relations departments to try to make sure they keep their Wall Street people happy, right? And fund companies have Morningstar relations departments to make sure they keep Morningstar happy. That's another thing to keep in mind. The other thing to keep in mind is that there are flat-out biases created by the Morningstar fund flows, right? Because there's a Vanguard study that showed little evidence of outperformance by 4 and 5-star rated funds. It's the 5-star kiss of death, right? If by the time you get rated 4 or 5 stars, so much money flows into you, you can't execute the strategy anymore. Right. And in this article, we point out how actually a lot of money managers purposely change their categorization in Morningstar so they can be higher ranked relative to other firms. So they raise more assets just because they're more highly ranked relative to other firms, even though their performance stays exactly the same. They go from small-cap— they go from small-cap value to small-cap growth. And because there are no good funds in small-cap growth, Where there were more good funds in small-cap value, they're now ranked more highly and therefore get more assets. It happens. Another great article we did is on the idea that the rating system is biased, right? What does this ratings distribution look like? I'll use this chart here. It's a little bit easier to see. What does this show you? Let's see, 38%, the most of all its ratings, the majority are gold. Next is silver, next is bronze, next is neutral. Oh, negative is the least. 4% of all ratings are negative. Kind of like Wall Street ratings where like 2% to 4% get a sell rating. Hmm, similar, similar bias, similar rating distribution. Now, let me— this article was written a while ago, so this distribution may have changed, but this is what it was like when we did the research back in March of 2012. I think the distribution is still very, very skewed, though maybe not as skewed as it So that's a key point, right? You know, and all the research that you, that you see on stocks and ETFs tends to be focused on primarily one thing: past price performance, right? Here's our methodology page for our fund rating system. Past price performance is how most people analyze mutual funds and ETFs. We actually look at an ETF and a mutual fund the same way we look at stocks. So all the time that I spent talking about how robust our stock rating system is and all the detail that we do in the footnotes and the MD&A, all the work we do to get to the truth about profitability and to analyze valuation, work that's so good that it gets featured in Barron's and SumZero, all that work we do in stocks, Guess what? It contributes directly to the quality of the research you get on mutual funds because our rating on a mutual fund is going to be primarily based on the same thing that we base our stock ratings on, right? Those of you who've seen my webinar on stock ratings and said we focus on the stock ratings, well, you'll notice that this is the same exact criteria because the same criteria that drives our stock ratings is the same criteria that drives our mutual fund ratings. With a couple small tweaks, all right? 90% of what the rating is driven by is the quality of the holdings. There's no such thing as a fund in our system that gets a bad rating on the quality of holdings that gets a good rating in any other way. It is the predominant driver because you know what? The performance of the mutual fund is driven by what? Money. Anybody who answers this question in the next 10 seconds. Gets a free membership to a Gold or gets one of the free special offers. What drives the performance of a mutual fund or an ETF? It's holdings. So maybe you should analyze the holdings. All right, those of you who did answer in time, I'll be sure to make— I'll make sure that you get your appropriate prize. So what drives performance? That's a radio trick. I don't know if it works well in webinars. I guess for people who are listening to this when it's not live are going to be bummed out they missed out on the prizes. But anyway, good for you guys for listening live. The key takeaway is that performance is going to drive— sorry, the stocks are going to drive performance. The holdings are going to drive the performance, not the costs, but the actual holdings. So you can see This portion of our— this is our fund rating system, right? Business strength, valuation, these are exactly what drives stocks. Now we add a couple overlays. We're gonna ding the fund if they have most of the money in cash. We don't think mutual funds should charge you fees to put money in cash. You can do that yourself. There may be some funds that you like to invest in because they're really smart, strategic, and they go to cash at the right time. Okay, good. Go for that. That's fine. But for the most part— You shouldn't be paying someone to have your money in cash. That's not cool. You can make money, not a lot, but you can make money by having your money in cash. You shouldn't be paying someone to make money putting your money in cash. Then we look at total annual cost, and I'll go into detail on our total annual cost rating. That's the best measure of the all-in cost of being in the fund. It's the complete measure of the all-in cost of being in the fund, including trading costs and turnover. That's a hidden cost in mutual funds that you don't ever know about unless you use our research. So why do we care about this in particular today? Well, because we just launched our 3Q, 3rd quarter 2015 sector ratings for ETFs and mutual funds. We will soon follow this report with a report on every single sector and every single category for ETFs and mutual funds. We will do an in-depth dive on each of these 10 sectors. You can see how the sectors rank. We only have one attractive sector, consumer staples. 5 neutral, 4 dangerous. All right? And we'll also provide detail. On our top, you know, our favorite ETF— I'm sorry, our favorite mutual fund within consumer staples, our least favorite mutual fund within energy. And we'll also show you a distribution of ETFs and mutual funds by predictive rating. You can see only 7% of our mutual funds get a very attractive rating, 13 attractive, 41 neutral, 34 dangerous, and 5% very dangerous. Okay. Right, a normal distribution. It's a normal distribution on purpose, right? No more than 10% get a very attractive rating. No more than 10% get a very dangerous rating. All right. When we actually did this purely based on the holdings themselves, it was something like 90% were neutral or dangerous. It was just— it was a normalization of our stock ratings, which are, as you can see, not nearly as normal. Right, here's the ratings distribution for new construct stocks. All right, we do not normalize this. You don't get a good rating in a stock just because we need to have a certain number of stocks have a good rating. You don't get a good portfolio management rating from new constructs either just because we need to have an overall enough decent mutual funds out there, right? And that, that's, that's kind of, I think, a key point when looking at Our ratings when it comes to mutual funds, even though we normalize the overall rating for the mutual funds, right? This is the overall rating. Whoops. Even though we normalize the overall rating, we do not normalize the portfolio management rating, which is the stock portion or the key portion. This is where we analyze the holdings, and you'll see that as part of our— Overall rating, the portfolio manager rating. That does not get normalized. This does not get normalized. Only this gets normalized. So we're completely transparent as we are in everything we do. So, you know, also what's really neat is when you're looking at our system, right, you've got stock, stock, stock, mutual fund, mutual fund. ETF, right? You can have all these items side by side compared to each other so you can get a good sense of what looks good and what looks bad on a consistent basis. If you want to get more detail about the mutual fund rating, here it is. All right, this is what we think about the Goldman Sachs Dynamic Allocation Fund. Decent quality of earnings, not so bad valuation, asset allocation is terrible, and it's super expensive. What does that mean? Well, you click on a ticker, and you can see the details in our report. What this shows is that these guys are charging you— their total annual cost is 4.61%, right? And it's nearly— 4.6%. As you can see in this pie chart, 46% of the fund is in cash. You're paying 4.6% to be mostly in cash. We have a fairly large amount that are unrated, but the rest of the holdings are not so good either, or not so great, right? We got as much in neutral as we do in attractive and very attractive. Between neutral and dangerous, we got as much as we have in attractive and very attractive. But the key part here is this pie chart. It is exactly how they allocate their portfolio. 46% cash, 7% very attractive, 2% dangerous, 14% neutral. You get the idea. On the total annual cost front, I really like to talk about this one because this is amazing work. We go in and we look at transaction costs across all funds. The turnover in this fund annually is 211%. That implies about 1%, 1.1% in costs every year. All right? In addition to that, this particular fund's got a 2% load. The expense ratio is 1.43%. When you annualize it over 3 years, right, because you have to take into account the opportunity cost of the expense ratio. It's not just 1.26% because 1.26% of your money gets taken out of that fund every year. And if it were to stay in and grow, Well, you would have an even greater performance. So we take into account the opportunity cost of the expense ratio when calculating the average expense ratio and its impact annualized over a 3-year holding period. Right? So basically what this means, when the benchmark is 0.1 and your total annual costs are 4.61, to justify its total annual costs, GDAFX must outperform its ETF benchmark for cost by 4.1% annually over 3 years or 3.01% over 10 years. That's some awesome detail. And by the way, you can look at this apples-to-apples across all funds. So if we go to our mutual fund screener, we want to see all the telecom and large-cap funds, click here. Then we can sort by total annual costs. These are the most expensive ones. These are the least expensive ones. Very simple, right? I think— I'm not sure what level of subscription, but not every subscription has this more detailed analysis, but you can also screen on things that are, you know, will help you kind of cut through the noise a little bit better. So let's say we're going to take off all these requirements. We only want stuff that's got $2 billion more, $2 billion in assets under management or more. The initial minimum needs to be, you know, less than $5,000. And we want our total annual cost to be less than, because we just don't feel like it's fair to pay that much. Less than 2% a year. Bam! How many funds are out there like that? Well, quite a few. We got 7 pages of them, right? 7 times 50, about 350. So again, very powerful way to look at mutual funds. All right, we're about— we're a little over halfway in, so this is typically where I start to take questions. So please submit questions at any time. I know I got a little off track, but I did want to make sure I highlighted that we are— we published our sector ratings for the beginning of the 3rd quarter here, and we are going to be publishing reports on each and every sector over the next coming days. Those will be available. I think you have to be Gold or above subscriber to access those reports. You can check for sure on the membership page, which will detail who gets what. Everybody gets the sector ratings report and the best and worst funds reports. And the comprehensive sector analysis, you have to be Platinum or above to get that. Same for the market cap and investment style. So we'll do a detailed report on large-cap value Small-cap value, large-cap blend, large-cap growth, all of that in particular. First question, so can a fund be attractive even if it has higher-than-average fees? Not really. So, you know, a lot of that depends on what you determine is average fees. Well, we write some report on— write some good reports on that, in my opinion. So let's take, for example, let's go to the research section and look at sector ratings. And it'll talk about how to avoid the worst sector mutual funds. Right. So if we're looking for mutual funds, High fees is one thing you should avoid to avoid the worst, right? And 1.90% is the average total annual cost across all 649 US equity mutual funds, US equity sector mutual funds. So we'll do a search on and see if there are any funds that get a very attractive or attractive rating that have total annual costs above 1.9%. Answer the question. We'll set this to 0 so we don't, you know, and it's got to be greater than or equal to 1.9, and you got to be very attractive or attractive. There's a few, not many, right? And a lot of this is going to depend on, like, so if we go into detail on this fund, you'll see that you can't be over a certain total annual cost and still get attractive or very attractive. And let's see here, let's see the quickest way for me to get detail on this. Let's see, we'll add this fund to my review portfolio. Go into detail. So if you're above 4%, I'm pretty sure you can't get one. I'm pretty sure that's the case. And there's not a hard and fast rule. But I think it makes it really difficult when this gets to the worst possible rating. But let's check. It's a fun thing to check. Greater than 4%, attractive, very attractive. None, right? So if you're that expensive, you're not going to get— No. You're not going to get a— it's not possible for you to get a very attractive or attractive rating, which I think makes sense, right? I think it makes a lot of sense. Another thing that we do at the end of every quarter, which will give you a recap so you can quickly access all the sector ratings, right? Here they all are. These are the sector reports. that we provided on each and every sector in detail. And this is what you get from Platinum and above. But we'll highlight the top 5 best ETFs, the worst ETFs, the best mutual funds, the worst mutual funds in each and every sector, highlight some of the best stocks in there too, uh, to give you a good sense of what, uh, what stocks are also good within each sector. But here you get a sense of the number of good funds and the dollar amount in each of the funds. So I think that's always interesting because not always— all the money is not always in the best funds. All right, I got another question here. In terms of the sector ratings, does the neutral rating— because you see a lot of our sector ratings Are neutral. Does this skew more towards hold or sell? It's more towards hold. Dangerous and very dangerous are sell ratings. Next question. What percentage of ETFs and mutual funds are very attractive? Well, that's in the methodology. I think we detail that. So we can answer that question. Here's the breakdown: 10% very attractive, 20% attractive, 40% neutral, 20% dangerous, and 10% very dangerous. That was an easy one. How can funds get away with advertising such a low expense ratio if the total annual cost is so high? How do companies get away with overstating their earnings so much? That's a great question. And you know what? It's the same answer I have for a lot of stuff. How do companies get away with overstating their earnings so much? How does Wall Street get away with publishing such blatantly biased research? How does Morningstar get away with publishing such blatantly biased research? How do funds get away with publishing a low expense ratio when having a high total annual cost? The answer is because nobody's doing the homework. If you did your homework on Wall Street research and you read a disclaimer and the disclosures in Wall Street research, I challenge each of you, read— next time you get your hands on a Wall Street report, read the disclosures, all right? And then write me an email, david.trainer@newconstructs.com, and let me know honestly if you didn't get a little bit sick to your stomach. Right. If you loved it, tell me that too. Right. And I'll talk about it on the podcast. I'll say, hey, I was wrong. Somebody was really pleased by the disclosures in the Wall Street report when they read, you know, how potentially conflicted the Wall Street firm could be. Maybe you like that. I don't know. I'll be honest. But take a look at one of those. Same is true with the mutual funds and their costs. Nobody's going through and doing the diligence and looking at all the costs. Nobody's pulling it together. Do you think that's going to help advisors sell mutual funds if they focus on the complete cost as opposed to the low cost? Are you kidding? No. They want to focus on the lowest number possible so it's easier to sell you something. By the way, it takes a lot of work to do this, right? To build models, to make sure you take into account front-end load, expense ratio, back-end load, redemption fee, transaction costs. It took us like 6 months to build these models and handle all this data and do this across 10,000 mutual funds. We're really fast and good at what we do, but it still took us a lot of time and work. We spent weeks and months talking about the methodology on transaction costs and the cash component, cash allocation. It took us a long time. We put a ton of thought into this, a ton of thought. That's why you hear me talk so confidently about what it is we do. We put an enormous amount of thought into our technology, into our methodology, and that's why we feel so good about it. That's why we like to talk about it. That's why we're transparent about it. We'll show you the methodology. You know, like, for example, you want more details on total annual cost? Here it is. Here's the distribution of total annual costs, right? How many companies have more than 10%? Well, there's 2, right, at the time of publishing this article. But it talks about everything we do here, and it even refers you to the paper that we use in order to translate turnover, which they produce or they provide in the footnotes of the manual, of the Mutual fund version of a 10-K. Buried deeply in those filings, you will find the turnover numbers, which we translate into transaction costs based on the methodology in this— in that paper. Right? So again, 100% transparent. You want to know the methodology behind our asset allocation? There it is. Strategic cash versus Versus frictional cash methodology. Here's the cash percentages, right? This obviously was done before the Goldman Sachs guys had nearly 50%. The mass majority of funds, 94%, have cash percentage less than 8%. These have a neutral or better rated asset allocation rating, and their predictive rating is not penalized. All that make sense, right? If you're below average, we're not going to penalize you. If you're above average, we're going to penalize you. How often do we correct? Great question. So we've done some, some reports here that compare our ratings to Morningstar, and we beat them in isolated cases. We don't have a— we don't have a subscription to Morningstar, so we can't sort of do a full-on, like, comparison apples to apples, but In the situations where we've been able to identify research where they say they like it and we don't like it, we've beaten them. If you want to look at the— we have not put together a big report analyzing our success in predicting fund performance, but the primary driver of our fund ratings is stock ratings. I think you've all seen me many times talk about our past performance tracking. And our stock reports, our stock ratings do very well, right? So we believe the quality of our stock ratings is what drives our fund ratings. If the quality of our stock ratings is good and they're predictive, then we think the fund ratings are predictive as well. But we don't have a bunch of detail on that, and I know that's kind of lame. Um, we can't do everything all the time. We'll probably backtest that in the not too distant future. So another couple questions here. Some stock dangerous ratings are caused only by high share price, while others are caused by earnings quality. Is there a way to screen for individual factors in your rating system? That's a stock-related question. I'll take it quickly. So in our screener, if you want to look at everything on an overall rating basis, and then you can then qualify certain stocks out by putting thresholds in here that are higher. So if you want to make sure that you— for all the stocks that get a very dangerous or dangerous rating and they have a return on capital greater than 20%, Those are going to be guys with good quality earnings almost all the time, at least decent quality earnings. So let's take one of these. Let's add it to my portfolio. We'll put it in the review portfolio. We'll go take a look at it down here. So, eh, not totally high quality earnings. There is a way to do that in a more sophisticated way in our dynamic data, which is what our institutional clients have. So if you want to look at the overall rating, Add that, and then you would look at the quality of earnings ratings, which would be rating economic versus reported, and then rating ROIC, right? And so then you can go in and get all the ratings and do a big screen based on that. So you can get that kind of data from our system. And, you know, we're publishing reports analyzing that kind of stuff on the fund level in a lot of ways as well. Okay, that's all our questions. Hey, it's all the time we have. That's all we have time for. You know how to follow us on Twitter. Email us at support@newconstructs.com or david.trainer@newconstructs.com. Thanks, David. We are expanding coverage pretty radically these days. In the not too distant future, our parsing technology, which I don't know if we've ever done a webinar on how awesome our parsing technology is, but we have the best capabilities in the world for gathering data, and that technology is making some fairly quantum leaps going forward. I have to say I'm extremely proud of the work that our analyst team is doing and our technology team is doing. To take advantage of the pretty incredible framework we had in the beginning that they helped us— that they built already. But we are leveraging natural language processing and some other fairly contemporary— I wouldn't want to say new, but contemporary technologies to drastically increase the amount of automation and intelligence in our parsing system, which means we're going to cover more companies, which means we're going to cover more funds. Look, new constructs always getting better all the time, never satisfied with the old constructs, always building new constructs. And with that, I wish you a happy holiday. Please don't forget to fill out the survey.