Is Morningstar's New Investor Return Stat Useful?

I read an interesting article in Morningstar Advisor Magazine this week about Morningstar’s new Investor Return (IR) statistic. This performance figure is an asset weighted return, in other words it adjusts return for the movement of assets in and out of a fund. Morningstar is touting IR as indicative of the return that an average investor in a given mutual fund received rather than that actually posted year to year by the fund.

The fund industry hates this measurement because in most cases, over the last ten years, IR trails the actual return of the fund. The fund industry’s point is that this is not their problem because they cannot control investor behavior. I agree; one of the most frustrating problems with managing OPM (other people’s money) is that you cannot control when people bring you money. Investors do tend to want to invest money when the market is doing well and not invest or sell when the market is not doing well. This is human nature and very difficult for most of us to overcome. The financial press is touting the IR statistic as some new revelation in its ongoing and long running “how Wall Street screws the little guy” expose. Although this one’s a little hard to swallow, their point seems to be that the fund industry somehow actively encourages poor market timing behavior by investors.

The Morningstar Advisor article by Christine Benz, Morningstar’s Director of Fund Research, looked at IR from a variety of perspectives and found that there were two key factors in the difference between IR and actual return. The first was volatility. The more volatile a fund’s return the more investors jumped in and out and the lower was the return for the average investor. The fund sectors showing the largest differences between IR and posted returns were, not surprisingly, technology and growth funds (both large and small cap). The second factor was stewardship of fund assets. Morningstar assigns a grade for stewardship ranging from A (best) to F (worst). Among the things that will cause Prof. Morningstar to trash your stewardship GPA is not actively discouraging frequent trading. Frequent trading in a fund is a key factor in lower IR for a number of reasons, the most notable being the greater possibility of poor investor timing and higher expenses for all shareholders. The number crunchers at Morningstar calculated a success ratio for fund families by looking at the percentage of the posted return actually earned by the average investors in that family of funds. Fund families with higher stewardship grades tended to have investors with higher success ratios.

I was pleased to see Funds families that populated our managed portfolios earn high success ratios. Vanguard and Dodge & Cox were in the top 5 of the fund families tested. I consider mutual fund analysis to be one of Pilot Capital’s core competencies (stuff we’re really good at) so whenever some one comes up with a new performance parameter we carefully consider whether it’s of any use in our process for choosing managers for our managed portfolios and/or evaluating the effectiveness of client-managed portfolios that we are asked to evaluate as a consultant. In this case I found the IR performance statistic to be of little use other that to verify that the research parameters that we are already using are leading to good decisions regarding manager selection.

Pilot Capital’s mutual fund research effort is designed to provide our portfolios with mangers for each asset class that supply the best and most consistent performance available in that asset class. Consistency of return is most critical. It is a constant source of wonder to us how few people in the fund business fail to see that their job is to compound money for shareholders. Among the parameters we use to evaluate fund mangers are the ability to consistently finish in the top 25% of peer group, Sharp Ratio (a measure of management efficiency), cost and quality and consistency of investment philosophy (we like people who stick to their knitting and knit in ways we understand and feel comfortable with) and… stewardship of shareholder assets. So it was very satisfying that the fund families we use tended to have high IR’s. All the folks at Morningstar managed to do with IR was provide some means of verification for what an intelligent, fundamental, commonsense approach to fund selection should do anyway and to reprove once again that the very large majority of human beings make lousy investment decisions because they’re, well… human.