Where Active Fund Investors Were Flocking to & Fleeing From in 2016

We all have heard about the ongoing industry shift from Active to Passive Funds as illustrated below via Morningstar

However, despite Active funds as a whole being in net redemptions...there are still net winners and losers. Below I have highlighted the Active Mutual Funds within the largest 15 Morningstar categories with the most net inflow and most net outflows in 2016.

While this does tell you investor preference for 2016.....it also might just highlight investor short-termism. While some may have been due to legit concerns about a recent manager departure (Virtus Emerging Markets Opp and Pimco Total Return come to mind). A lot could have simply had to do with bad performance the year before in 2015. In fact, of those listed with the most outflows....11 of the 15 lost to their benchmark in 2015.

However, it seems investors may be overly focused on shorter term returns, because heading into 2016 12 of those 15 funds with the most outflows had records of 10yrs or more.....and 9 of those 12 beat their benchmarks over that timeframe. While each situation is unique, history says investors shouldn't be given the benefit of the doubt....they historically make bad timing decisions when it comes to hiring or firing managers.

A Look At Sloppy Nonsensical Mutual Fund / ETF Analysis

I read a lot of stuff online so I should be used to sloppy-stupid nonsensical things written online. However, this one titled "Why ETFs Are Better than Mutual Funds, in Two Charts" hits it on every base of stupidity. Now usually ETF Database is a decent source of some good information but clearly the editors were asleep at the wheel on this one. Let the article speak for itself.

It starts off fine enough

"Though some may disagree, exchange-traded funds have certainly proved their worth over the years. With more than 1,500 products to choose from, more and more investors have turned to the ETF wrapper, embracing the vehicles’ low-costs, efficiency, and many other advantages."

All is good there. And so she continues

"Some investors and industry professionals, however, have not yet come to embrace these products, preferring mutual funds instead. For those who need some convincing, we’ll try to show you why ETFs are better than mutual funds, in two charts."

Great, let's see it.

"For this exercise, we take a look at the popular Emerging Markets ETF (VWO, A), comparing it to the GS Emerging Markets Equity Fund (GEMCX). First, a comparison of expenses:"

Whoa Whoa, wait a second, WHAT? First of all what made her decide to use Goldman Sachs Emerging Markets Fund? Furthermore, why would she use a C share? The fund also comes in other share classes including IR share class which comes in at 1.48% (we will also overlook the small fact that net expense ratios for those funds are 0.15% and 2.47% not what she has listed). The only people who might be using a C share are people working with an adviser and the advisers fee is being included into the expense ratio (but that is a discussion for another day). This is nowhere NEAR an apples to apples comparison showing why ETFs are better than Mutual Funds.

She goes on to point out the performance gap that this inevitably leads to 

And she concludes:

The Bottom Line

This is just one of many examples of how ETFs are often better than mutual funds. Not only are exchange-traded funds usually cheaper, but they are often more efficient than mutual funds. If we’ve managed to convince you, use our free Mutual Fund to ETF Converter Tool to find an alternative to your current mutual fund.

Sorry, you have not managed to convince me and hopefully you didn't convince anybody with your ridiculous comparison. I hope your "converter tool" has a little more logic then is displayed here. So what is a PROPER comparison of the ETF VWO if you are trying to see the difference between mutual fund and ETF structures? Well the very simple and logical comparison would be Vanguard's Emerging Markets ETF (VWO) to Vanguard's Emerging Market Index Mutual Fund (VEMAX).

Only problem is that when you show a REAL comparison, your point is pretty much lost . As you can see, looking at the complete common period between the two funds, there return is essentially identical.

Not only does a proper comparison make her performance point invalid, her point about cost is as well, as both carry an expense ratio of 0.15%. But just for giggles lets throw in Vanguard's Active version of emerging markets which is a little more expensive with an expense ratio of 0.94%. Unfortunately, their active emerging markets strategy hasn't been around as long (A little shy of 3 years) but as you can see it has managed to handily outperform. You may also notice that over this timeframe the index MUTUAL FUND slightly outperformed the supposedly superior ETF.

Rally Continues to Reduce GMO's Asset Class Return Forecasts

Investment Management firm GMO is well know for it's Asset Class forecasts it puts out. The continued strong rally in the market has officially moved their 7-year forecast for Large-Cap stocks (S&P 500) into negative territory, joining their negative forecast for Small-Cap stocks, US Bonds, Intl Bonds (hedged), and Inflation Linked Bonds.

You can see below the history of their forecasts. Through time it has shown to be a good general guide.

With so little looking attractive how are they investing their Benchmark Free Allocation Strategy I discussed here?

While this is from 12/31/12 not much has changed except a slight increase to their Equity Risk Premium Strategy (which is a put selling strategy) they are using as a substitute for some equity exposure.

Performance of Morningstar's New Analyst Ratings For Mutual Funds in 2012

Last year I wrote about Morningstar's new analyst ratings for mutual funds (here as well). These are different from their Star Ratings in the fact that these are meant to be "forward looking". From Morningstar (bold added by me)

"The Analyst Rating is based on the analyst's conviction in the fund's ability to outperform its peer group and/or relevant benchmark on a risk-adjusted basis over the long term. If a fund receives a positive rating of Gold, Silver, or Bronze, it means Morningstar analysts think highly of the fund and expect it to outperform over a full market cycle of at least five years."

Now it should be clear that these ratings are longer-term in nature so take the following breakdown with a grain of salt but I said I would follow-up on these so I am.

First lets start with a review of what the distribution of Morningstar's Analyst Ratings looked like at the start of 2012

While the distribution of ratings has gotten a little better it remains a mystery why Morningstar has an allergic reaction to assigning negative ratings. As of the start of 2013 they have now rated 1069 funds but only 52 (or less then 5%) have negative ratings. Although the neutral ratings have increased to 28%, Bronze to 25%, Silver is down to 24% and Gold down to about 18%.

Without further ado, below is how the rated funds performed in 2012. These only include funds rated at the start of 2012.

Not much really stands out after the first year. While their was a slight positive result for Gold and Silver rated funds, Neutral rated funds did even better. As for Bronze and Negative rated funds, outperformance was pretty much a coin flip.

Below is the Average Rank for each, as you can see Neutral rated funds performed the best and Negatively rated funds performed the worst.

Take this for what it's worth, which at this point is not much because full market cycles are indeed a better measuring stick. For instance, in 1999 and 2006/2007 a lot of bad managers did good thinking the unsustainable was in fact sustainable while a lot of good managers did bad as they realized irrationality when they saw it. However, this is at least a starting point for looking at the performance of these Analyst Ratings.

Morningstar Continues Rollout of Analyst Mutual Fund Ratings, Only 7% Negative.

Morningstar has been rolling out it's new "forward looking" analyst ratings for mutual funds since last November as I have touched on before. The number of funds rated has gone from 349 funds to 924 as of the end of the 2nd quarter (You can see the full list as of 6/30/12 here). While it has been good to see the distribution of ratings even out somewhat, Morningstar still appears to have an allergic reaction to rating funds "negative" as can be seen below.

As a reminder about the meaning of the ratings, per Morningstar....

"The Analyst Rating is based on the analyst's conviction in the fund's ability to outperform its peer group and/or relevant benchmark on a risk-adjusted basis over the long term. If a fund receives a positive rating of Gold, Silver, or Bronze, it means Morningstar analysts think highly of the fund and expect it to outperform over a full market cycle of at least five years."

After reading that you might assume that anything rated gold, silver or bronze is a fund Morningstar analysts think will provide risk-adjusted outperformance compared to a relevant benchmark over a full market cycle of atleast 5 years. Apparently not......as can be seen by the majority of ratings given to 29 index funds. Obviously you could not expect an index fund to outperform it's relevant benchmark....after all, index funds are designed to REPLICATE their relevant benchmark. So they should generally perform in line with the benchmark, minus fees. The best an index fund can hope to do is meet Morningstar's definition of neutral "Fund that isn’t likely to deliver standout returns, but also isn’t likely to significantly underperform".

Despite the fact that by their very nature index funds can't be expected to outperform their relevant benchmark, of the 29 index funds Morningstar rated, the ratings breakdown as follows: 14 Gold, 9 Silver, 3 Bronze, 2 Neutral, 1 Negative. It is true that the majority of actively managed mutual funds underperform their benchmarks as can be seen below (you can see more in S&P's Indicies vs Active Report). However, the reality is index funds always underperform their benchmarks! (unless a sampling error works in their favor).

However, what Morningstar should take away from the above info is not that index funds deserve metal ratings, what they should take away is that they need to be much more stingy in giving away Gold, Silver & Bronze....because the majority of mutual funds, ACTIVE & PASSIVE, underperform their benchmarks! If everyone knew that metal ratings only meant they would perform like their benchmark I doubt anyone would care for that information, yet Morningstar thinks that is exactly what they should do.

My 3 Favorite Mutual Fund Managers for Navigating the Market Going Forward

The mutual fund world has no shortage of managers. But when it comes to finding managers which have a rock solid understanding of market history, a real grasp of the true drivers of long-term investment returns, a strategy for capturing those returns over time, an eye for avoiding market fallacies that lead the herd and most importantly -- know what it means to be stewards of Other People's Money. Well, that list is much shorter.

Most of the investment landscape is filled with products in a race of relative performance. It is rarely about making decisions to maximize long-term returns. Too often it is only about making decisions to outperform some index -- without making any decisions that might lead to temporarily underperforming that index, even when it is the best long-term decision. Therefore, it is a world of closet indexers and many of those who don't closet index still wouldn't dare be anything other than 100% invested.

While there are some very good managers who only manage funds with less flexible investment mandates, my purpose here is to highlight my 3 favorite mutual fund managers with the flexibility for navigating the markets . This isn't about past performance -- these are the managers I would feel most comfortable allowing to manage my money over the next full market cycle for the reasons described at the start of this post. Is it subjective? Of Course! This is MY list (and in no particular order).

Rob Arnott (Pimco All Asset and Pimco All Asset All Authority)

At Pimco essentially everything is managed "in-house". That is except for these 2 funds sub-advised by Rob Arnott of Research affiliates. These are tactical asset allocation strategies and the only limitation for Rob is that he must use Pimco Funds and abide by these very loose guidelines.

Rob Arnott is a great "big picture" guy and truly understands valuation. He is also well known for his fundamental indexes.

John Hussman (Hussman Strategic Growth)

This is not Hussman's only fund but it is his flagship fund and where he has the majority of his own investable assets. Hussman invests the portfolio like a traditional equity fund and then "hedges" using index options and futures based on his outlook for the market in general -- which has resulted in a highly hedged stance most of the time.

Someone might look at his performance year-to-date (-6.8%) while the market is up 11.1% or point to his performance over most of the rally since 2009 and think I'm crazy. Hussman is catching a lot of flak recently and you can see his response in one of his commentaries from February "Notes on Risk Management - Warts and All". But as I said before -- this isn't a backward looking list of my favorite mutual fund managers.  

There aren't many that understand the drivers of long-term returns more than Hussman and I think his ability to stay true to his strategy will prove out in the long run (the next full market cycle). Even if you don't invest in his fund, his weekly commentaries are always worth the read.

Ben Inker (GMO Benchmark-Free Allocation and Wells Fargo Advantage Absolute Return)

This is less a story just about Ben Inker himself and more about all the people at GMO including Jeremy Grantham and a more recent addition of James Montier. It is a good meeting of the minds there at GMO and their Asset Allocation Team.

The GMO Benchmark-Free Allocation Fund is actually not open but they started a distribution agreement with Wells Fargo in March. Therefore the strategy can be accessed in mutual fund format through the Wells Fargo Advantage Absolute Return Fund. I personally like the GMO name for the fund better -- but I am assuming for marketing reasons Wells Fargo chose the "Absolute Return" name. I am personally not a fan of most "Absolute Return funds" I see in the market, as most are nothing more than a giant ball of derivatives (but that's another story). 

Wells Fargo already had a fund (Wells Fargo Advantage Asset Allocation) sub-advised by GMO but the investment mandate did not give GMO very much flexibility in the allocation. You can see the difference this flexibility made below.

Jeremy Grantham talks about the advantages of flexible investment mandates, as well as the "career risk" it introduces in GMO's most recent quarterly letter (definitely worth the read).

There you have it!

It is important to remember this is not my 3 favorite managers for the next month, or the next year. These are my favorite mutual fund managers for the next full market cycle. Some will perform better than others during different parts of the cycle. For instance, if the market were to begin falling tomorrow, based on current positioning, I would expect John Hussman's Strategic Growth to perform best, then Rob Arnott's All Asset Strategy (either one), then Ben Inker's Benchmark-Free strategy. And obviously opposite if it continued up.

Morningstar Ramps Up Analyst Ratings for Mutual Funds. Positive Bias Continues.

UPDATE: 8/1/12 - You can see updated ratings as of 6/30/12 here.
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Morningstar continues to roll-out its new 'forward-looking' analyst ratings for mutual funds. When I wrote about these ratings in November after their initial launch they had ratings for 349 funds. They have increased that to 410 (as of 12/31/2011). You can download the complete listing here.

As a refresher here is what Morningstar says about it's new rating system

"Unlike the backward-looking Morningstar Rating™ (often referred to as the "star rating"), which assigns 1 to 5 stars based on a fund's past risk- and load-adjusted returns versus category peers, the Analyst Rating is the summary expression of Morningstar's forward-looking analysis of a fund. Morningstar analysts assign the ratings on a five-tier scale with three positive ratings of Gold, Silver, and Bronze, a Neutral rating, and a Negative rating.

The Analyst Rating is based on the analyst's conviction in the fund's ability to outperform its peer group and/or relevant benchmark on a risk-adjusted basis over the long term. If a fund receives a positive rating of Gold, Silver, or Bronze, it means Morningstar analysts think highly of the fund and expect it to outperform over a full market cycle of at least five years."

So far it appears that this system is going to suffer from the same problems which plague stock ratings.....a lack of negative ratings. Despite the fact that the majority of mutual funds under-perform their benchmarks, only 4% of Morningstar's 410 analyst ratings are "negative".

Morningstar has still not clarified how 21 index funds have managed to receive "metal" ratings. After all, how does an index fund outperform it's benchmark? By their own definitions, the best an index fund should be rated is "neutral". Yet every index fund they have rated up to this point has received a rating higher than Neutral (with the majority getting 'gold' ratings).

Below is a chart breaking down fund attributes by each rating

Nothing too shocking here. The average fund receiving their highest "forward looking" grade also has a higher backward looking star rating. Fund expenses are lower and manger tenure is longer. The most questionable aspect comes into play regarding fund size. Many funds that performed well in the past did not necessarily do so with large asset bases, the assets usually came after the performance. With "gold" rated funds having such large asset bases on average, will they be able to outperform going forward?

I will be checking up on Morningstar's roll-out of their new ratings from time to time and will definitely check up again this time next year to see how this batch of ratings has performed.

Are Morningstar Mutual Fund Analysts Taking Happy Pills? Ratings Breakdown.

UPDATE: 8/1/12 - You can see updated ratings as of 6/30/12 here.

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So Morningstar has released new "Analyst Ratings" on 349 US based mutual funds as of 11/15/11. According to Morningstar

"The new scale runs from Gold, Silver, and Bronze on the positive end to Neutral and Negative. Expressed as medals, the top three tiers are reserved for funds our analyst team thinks have sustainable advantages that position them well versus peers and a relevant benchmark on a risk-adjusted basis over the long haul (at least the next five years)"

Morningstar considers Gold, Silver and Bronze to be positive analyst ratings. And obviously the other two are self explanatory. The exact definitions of each are below

Gold: Best-of-breed fund that distinguishes itself across the five pillars and has garnered the analysts’ highest level of conviction;  

Silver: Fund with notable advantages across several, but perhaps not all, of the five pillars—strengths that give the analysts a high level of conviction;

Bronze: Fund with advantages that outweigh any disadvantages across the five pillars, and sufficient level of analyst conviction to warrant a positive rating; 

Neutral: Fund that isn’t likely to deliver standout returns, but also isn’t likely to significantly underperform; and 

Negative: Fund that has at least one flaw likely to significantly hamper future performance, and is considered an inferior offering to its peers.

However, one has to question the way these ratings have been given out for this first batch of 349 funds. 

These must be the parents of Generation Z giving out these ratings because apparently they think you deserve a metal just for showing up. Of the first 349 funds rated, a full 311 or 89% received a "positive" rating deserving of a "metal". Another 30 they are indifferent about and they only have a negative view on 8 or about 2%. 

However, many studies have shown that the majority of actively managed mutual funds actually underperform their benchmarks. Below is a chart from Mclean Heuristics using data from Standard and Poor's Indices verses Active Funds Scorecard.

Clearly that is a sad showing for active managers as a whole. But lets get one thing clear.....I am NOT a supporter of index investing. In fact, I believe index investing (particularly using cap-weighted indexes) only adds to market inefficiency (but that's a rant for another day). 

However, what that chart does show is that if Morningstar was properly distributing it's ratings, it would likely be an inverted version of what they put out. With the majority falling in the "negative" category and the least falling in the "gold" category.

We'll see how the distribution of ratings turns out as Morningstar rolls out more over the next year, but so far it looks to be just as ridiculous as stock ratings given out by the industry. Analysts as a whole in the financial industry are not in short supply of happy pills. After all, Happy Sells!

Updated: 11/17/11 10:20pm ET