|Scott Cooley of Morningstar.
|How did you get started in the financial industry? My first job right out of school was as a bank examiner for the Fdic%86 in Chicago. We had to go to Washington, DC, for training sessions periodically. One time, I decided to take the trip on Amtrak instead of flying, and found myself seated next to Don Phillips, the chief executive officer (Ceo) of Morningstar. I was interested in investing and knew about the company, and Phillips is a charismatic and bright person. I talked to him for a couple of hours and I was impressed; I figured if I ever had a chance to work for a company he was running, I would take it.
A couple of years later, I saw that Morningstar was looking for analysts, so I applied. If I had been seated next to someone else on that trip, who knows what I would be doing right now!
Did Don Phillips know who you were when you applied? No. I mentioned I was interested in working at Morningstar because of him, but I didn't contact him. I figured he's an important guy who meets a lot of people and probably wouldn't remember me, but he was giving an orientation, and when I introduced myself afterward, he remembered me. The man has phenomenal recall. He remembered meeting me on the train. One reason it stuck in his mind is that his wife works for the Federal Reserve, so we talked about that. She's not a bank examiner, but the Fed does some exams, so it stuck in his mind because of that. That was just one of those goofy turns life takes. I think I would have ended up doing some kind of investment-related job anyway, but I'm not sure I would have found Morningstar otherwise. I consider myself lucky.
What's your primary function at Morningstar? I'm one of the analysts on the mutual fund side. Basically, we try to evaluate how well fund managers execute their strategies. We also try to get people enough information so they can make better investment decisions than they might on their own. Part of that is pointing out some of the important features of the different funds.
Like what? If a fund performed well, did it do so by taking on a lot of risk, making a huge sector bet that happened to work out, or was it more a case of systematic value added through bottom-up stockpicking, which is more likely to be sustainable?
What do you look at? We look at fund costs relative to expense ratios and compare them to similar funds. If they're too high, we want to point that out so people know what they are dealing with. Part of it is quantitative and part of it is qualitative. We periodically interview portfolio managers. If it's a big fund, we usually talk to them once a quarter and go over the portfolio changes, and try to evaluate whether they are consistent with the stated mandate of the fund. We want to keep abreast of performance and see if the fund is behaving as it should. Is it doing well relative to its peers?
Let's backstep to the evaluation of the fund managers. What factors do you look at, specifically? We classify funds in peer groups of similar funds. That's pretty intuitive. No one would say it was fair to compare the Standard & Poor's 500 index with a fund that tracks Japanese small-cap stocks.
The classifications are based on the underlying portfolio holdings. Our belief is you can't really classify funds by what they say they're going to do but rather by looking at what they've actually done. We look at the portfolio holdings of a fund over the last three years and we look for the kind of characteristics the fund had on average over that period. We make it as mechanical as we can to put it beyond the realm of argument.
Do you place emphasis on the objectives stated in the fund prospectus? No. Instead of using the objectives in the fund prospectus such as growth and income or value, which does not differentiate between small-caps or large-caps, we separate them into value, blend, and growth based on the portfolio characteristics. A further classification in US domestic stock funds is small-cap, mid-cap, and large-cap. So it becomes a nine-box grid that groups funds.
Can you give me an example? Sure. For instance, all large-cap growth funds will be grouped together. This way, we can see who is really adding some value with stock selection and who just happens to be operating in a part of the market that may have been hot recently. In 1988 and 1989, funds that used a small-cap value investment style tended to have poor returns relative to the broad market. However, when a fund manager always sticks to one investment style and generally does a good job with it, you don't want to unfairly criticize the manager just because that particular investment style is out of favor. This year, the average small-cap value fund is up well ahead of the S&P 500. So you want to put yourself in a position where you are comparing apples to apples and not apples to oranges.
What else makes a good fund manager? We look for a good supporting cast as well. We visit fund companies to make an assessment of that. We like to talk to people we normally wouldn't get a chance to when we make our calls to fund managers. We like to meet with someone different on the inside. For example, at Fidelity, at least once a year we meet with the people who don't show up on the Morningstar page or don't get quoted in publications. We try to get a sense of how knowledgeable the people backing up the managers are. An ideal manager is someone who has been in the business for a while and has consistently demonstrated the ability to add value in terms of either less risk or better returns than an index. The way I look at it, an index fund is always an option for investors. For a manager to justify his or her salary and the additional costs of an actively managed fund, that person has to be able to add some value to the fund, or there is no point in buying a non-index fund.
How would you define value? In a couple of ways. We would look back historically to determine if a manager added value. One method is to look at another fund or index that would be an appropriate benchmark for that fund and determine whether the manager beat that benchmark. So for example, if a fund manager is responsible for a large-cap blend or large-cap core fund, we compare the performance to the S&P 500, since most of these funds look like it. We determine whether this manager has delivered better returns than the index. If that manager hasn't, then it's tough to recommend the fund.
What's the other way you would define value? The volatility of the fund. Did it bounce around? If a manager delivered index-like returns but in a less-volatile market, it means he or she took on less risk. In such a scenario, we would say that is value-added.
You can find pretty good style-specific benchmarks for most funds. You also have peer groups with active managers. If a manager is consistently at the bottom of his or her peer group, we want people to steer clear of that type of investment. We feel like we have a fiduciary obligation, even though we are not being directly compensated for giving advice. We try to make sure a fund manager adheres to a pretty consistent style and has done a good job.
|What are the steps Morningstar goes through to rate the mutual funds? The first thing to know is that the star rating is purely a mechanically derived rating. First, we separate funds into four very broad groups: domestic stock funds, international stock funds, taxable bonds, and municipal bonds. We look at how much downside volatility the funds within each group have experienced. In other words, how much does the fund go down when the market sells off. We look at how much the fund returned over longer-term periods like three years, five years, and 10 years, assuming the fund has been around that long. We look at how much the return exceeds what a risk-free instrument would have returned. We have always used the three-month Treasury bill for this.
Why the three-month T-bill? The idea behind it is that even a monkey could put money into a T-bill, since there's really no risk involved. We basically look at how much value has been added to a fund beyond the T-bill. The ideal fund, I guess, is one that has a lot of excess returns over the risk-free rate and that has not experienced a lot of downside volatility. In many ways, it's like a Sharpe ratio: You are looking at how much return there was for the amount of risk taken on. In fact, William Sharpe has written that there is a 97% correlation with the star rating and what the ratio tells you. So it's nothing necessarily Earth-shattering. Normally, the top 10% in each of those broad asset groups in terms of risk-adjusted performance would have a five-star rating, the next 22.5% would have a four-star rating, and the middle 35% would have a three-star rating. Then it's the same on the bottom end: 10% have one- and five-star ratings; 22.5% have two- and four-star ratings; and 35% have a three-star rating.
How does an investor use Morningstar aside from the ratings? We offer a lot of different tools. We always want to make it clear that we believe buying and selling based solely on the star rating is a losing strategy. The rating is just one piece of a very large puzzle that leads to an intelligent investment decision. Information is available either in the Morningstar mutual funds binder or from our Website, where you will get the most timely information. On a range of fund characteristics, you can look up a fund's expense ratio; its historical returns compared to a relative benchmark; or the management team or a group of peers compared with others of similar style characteristics. You can also see whether the manager who built the record performance of a terrifically performing fund is still there - which is always a big concern for most investors.
In addition, we write some pieces for our Website to help people analyze funds and keep them current with what's going on in the fund industry. We talk about how to build portfolios; most people own more than one mutual fund now. We have even written technical pieces, such as %93If you want to build an all-index portfolio like that of Vanguard, here's the best and most tax-efficient way to do it.%94
Some of it can be pretty narrowly focused. Investing novices who don't want to do a lot of researching on their own can, for a modest fee, subscribe to our Clear Future product, where you punch in some information that instructs the program to make determinations about your risk tolerance and investment time horizon, the funds in your 401(k), and so forth. The product will spit out a recommended allocation for you. You can go back once a month or once a quarter or once a year and plug it in again and see what's changed.
If you were going to point out a few things for investors to consider when they are putting together their mutual fund portfolios, what would they be? I would point to two things right off the top of my head. One is cost. It is easy to forget about the costs of your investments when the market is doing as well as it has been the last few years. When you go do some backtesting%86, one of the best predictors of funds' subsequent returns is how much they charge shareholders. The less they charge you, the more is going to be left for your returns.
What are the biggest costs that people should be worried about? Definitely look at the expense ratio. That's the cost that is pretty clearly stated in the fund prospectus, and it can be anything from 18 basis points to several percentage points each year, depending on the fund. For funds that do a lot of trading, there are some additional costs. If you are working with an advisor, you need to decide if you want to pay an upfront load or whether you want to pay a fee per hour or a fee based on your assets. A lot of people find that after they have accumulated a halfway decent amount of money, the issues are more complicated than they realized they were going to be. They have no idea how much money they can take out of their portfolio when they retire. They don't have any idea what's reasonable, they don't really know how to build a diversified portfolio, they don't know anything about estate planning. They decide they would rather hire someone to do it for them. But you have to decide how you want to pay for that advice.
What are important things to consider for when you're 65 and want to start pulling money out? The big thing is, you don't want to run out of money. That sounds really simple, but a lot of people assume the long-term return of the market when you go back to 1927 has been a little bit more than 11% per year. So their logic is if they take out less than 11%, they won't run out of money.
But-? But the problem is, those returns over the years haven't been smooth. A lot of the software that deals with this topic doesn't take this volatility into account. They assume an average return when they are figuring withdrawals. If you are fortunate enough to be in a position where you wanted to take out 8% while you gained 11% per year, that would work out well for you. But if you ran through some historical scenarios like the 1973-74 downdraft, someone who took 8% a year would end up without any money by the early 1980s. T. Rowe Price has a calculator at its Website that some people use, but some people would prefer to have someone walk them through all this and come up with the various scenarios. For example, if the market goes down 50% over the next couple of years and then bounces back some, how much money can I take out?
But don't most retirees switch their assets to interest-bearing funds? If you have enough money in your account, that's the way to go. The conventional wisdom has changed a little in that area because people are living so much longer than they used to. If you make it to 65, your life expectancy is around 20 more years, even though an overall average is for most people to live around 77 years. If you make it to 65, though, you have a good chance of living 20 more years or longer. If you are looking at a 20-year investment horizon, it probably makes sense to have some stocks. Most people probably don't have enough money to live off the interest of their municipal bonds. There is still the tendency to shift the money out of stocks, but it's not the tendency to be out of them entirely. This is because they will probably outlive their money if they don't have some higher-returning assets in there.
The other thing is, if you do live through a period of high inflation and you have too much in bonds, that can be a problem as well. My grandmother is an example. She and her husband owned a farm for a number of years. When she retired sometime during the 1970s - and I know she was not from the equity-investing generation - she only used ultra-safe stuff that was guaranteed by the government. Her standard of living declined significantly when inflation picked up. Even the amount of principal in real terms went down a lot in the late 1970s. This is the risk you run by having too much in fixed income.
|What's the second important thing for investors when building fund portfolios? Again, the first is cost. The second is diversification. The conventional wisdom now is to put all your money into tech-heavy growth funds and not worry about that value stuff, because it never goes anywhere. Don't worry about international, because the US market always does better. That's the conventional wisdom. That's how a lot of people think. Whenever I suggest it might be a good idea to put some money elsewhere, I get 10 E-mails telling me what a kook I am. The fact is, the market does go in cycles. For example, a great deal of the increase in tech stocks over the past few years has been because valuations have risen. The fundamentals have been good.
Most of the large companies wound up making more money,
just like they were supposed to. When stock prices rise faster than earnings, even when earnings are rising very quickly, there can always be a period of consolidation. Or if the fundamentals weaken, you are really exposed to risk.
What's an example? If you're in Cisco Systems and it's trading at 140, 150 times trailing earnings and its growth has slowed, you're going to get hammered. So it makes sense to spread your bets around. Historically, there have been all kinds of industries that looked like tremendous growth industries and delivered exceptional gains for a while, and then kind of petered out.
The funny thing is, when I started at Morningstar, everyone was talking about financials more than technology in 1996 and 1997. In 1997, the average specialty financial fund was up 46% and the average tech fund was up 9%. That wasn't that long ago, but people seem to have forgotten that. It makes a world of sense to spread your bets around. In 1989, there were probably people in Japan who thought it was stupid to put any money outside the Japanese stock market. I am not saying we are at that point. I think our economy is in much better shape than Japan's was then, with all the restrictions and regulatory problems they had. But people in Japan may have thought the Japanese market was never going to go through tough times.
One of the goals of Working Money is to have the younger workforce just beginning their careers understand how important it is to invest early on. What recommendations would you give them? The sooner you start, the more time you have for your money to compound. I think it was Albert Einstein who said that compound interest was the most powerful force in the universe. When you look at long periods, it's amazing what even modest contributions early on can do in terms of your ultimate lifestyle when you are older. I know it's hard for people to think about that, but it's so important to start early. And definitely get every dollar of employer matching funds in your 401(k) [Editor's note: See article elsewhere in this issue, %93Save For Tomorrow, But Live For Today%94].
That's 100% on that part of your investment right there! Yes, if you weren't contributing to your 401(k), you would be paying taxes on that money. In some sense, that might be a 200% return on your investment, depending on your tax bracket. It's an amazing difference. It's like getting a raise. People who would be upset if their raise were $1,000 less than they were hoping for will pass up employer-matching money. I find that difficult to understand.
The key is to get started early. If you get started early, you can afford to make a few mistakes. It's the people who wake up when they are 45 or 50 and realize they haven't saved anything toward retirement who are in a great deal of trouble. I'm afraid I know many people like that.
Out of curiosity, when did you get started in investing? My father made it very clear to me when I was about six that I needed to save my money. My parents grew up in the aftermath of the Great Depression. My father was born in 1935. He taught me a valuable lesson when I was growing up: if I have to cut back to put some money aside, I should do it. The other thing that drove it home for me was my career as a bank examiner. I started around the time the savings and loan crisis hit and there was a recession. I saw people who had good jobs and financial leverage lose their jobs and end up in bankruptcy court. That made me realize how important it is to establish good habits of saving and investing early on. If I could scare some kids into doing the right thing, I would. I know so many people who have good incomes but live beyond their means.
How often do you see mutual fund managers looking at the technical side of particular stocks? I'd say most managers primarily look at fundamentals, but many do consider technical factors along with fundamentals. There are some funds that explicitly use technical analysis, such as Fidelity TechnoQuant Growth, which uses certain price and volume characteristics to make stock-picking decisions. American Century Veedot is another one. That's a quantitative fund that uses some technical analysis explicitly as a major part of its investment decision-making.
From conversations with managers, I know that in the past there have been some softer uses of technical analysis. Maybe a value manager who buys undervalued stocks but doesn't sell when a stock hits a price target if it still has strong relative price momentum, meaning he wants to milk every last nickel out of the gain he can. So if a stock still has good share-price momentum, the manager might hold on a little longer before selling. Some funds use earnings momentum strategies such as earnings acceleration and positive changes in analysts' earnings estimates. It seems as though some managers say that using technical analysis seems dirty, but I suspect if you looked at these models, out of the 70 or so variables used by each fund manager, you are bound to find some technical tools used, such as share price momentum.
One of our goals is to show investors that a chart of a stock's price history is a culmination of everything that has happened in that stock up to that point. There's a lot to be said for the amount of information that individual investors can gain looking at charts of mutual funds or stocks. This is just an observation, but managers have said that when there is a big move in a stock, they assume someone knows something about that company. Somebody knows something, whether it's insider buying or an information leak. Those can be important clues to suggest more digging is in order. Every manager would like to say, %93I do fundamentally driven bottom-up analysis.%94 But in interviews, you hear things like, %93Well, we thought insurers would be a good way to hedge against a slowdown in economy because we want to shift out of banks.%94 But this type of comment isn't bottom-up thinking. Here's another one: %93We have an overweighting in semiconductors, but we attributed that to our bottom-up research.%94 Fund managers often say, %93We don't look at technical analysis and we don't do much top-down work.%94 This has become a standard line to use whenever it's convenient. It's probably a swing of the pendulum the other way.
What's the best way to get started if you had extra money and wanted to invest in mutual funds? You need to get a prospectus from each fund, so the first step is deciding which mutual fund prospectus to request. Screening tools are usually a good way to look for funds with good returns, low costs, and manager tenure - make sure the manager who built those returns is still there. We always recommend when you are buying your first fund to look for something that is broadly diversified and is a core holding. For most people, funds with stocks of large companies work out better. Then request the prospectus and make your decision based on what's right for you.
So we come back to diversification and costs? Yes. People sometimes make this more complicated than it needs to be, but I guess that's good because I might not have a job if they didn't! I think a lot of the simplest plans are often better.
If you had to pick a few mutual funds over the next couple of years, what would they be? I can tell you about a couple I own. The market has gone in cycles, and there's a good chance we will see value stocks outperform over the next few years. By definition, some stocks have lower valuations. There are a lot of fairly good, moderately growing companies that are available at very cheap valuations right now. One of them is Oakmark Select, which is a very concentrated fund, mostly in midsized company stocks definitely on the value edge of things. It's run by Bill Nygren, whom I consider to be one of the smartest managers I know. I feel as though I learn something new every quarter when I talk to him on the phone.
Another one I like, which is more of a measured play on value because it has a fair amount of technology, is Selected American Shares. It's a fund with a huge weighting in financials, and if I had to pick one sector I thought might do pretty well over the next few years, it would probably be that. I think the fundamentals are improving and the Fed interest rate hikes are pretty close to an end, and valuations are a lot more attractive relative to the broader market. It has about a 40% financial weighting and 30% weighting in some of the cheaper technology stocks. The fund opportunistically buys stocks like Texas Instruments - a couple of years ago, it wasn't the hot stock that it is now. Hewlett-Packard is another one they bought when it was down, and they've also been very successful with Ibm. They bought some semiconductor stocks such as Applied Materials a few years ago, when they were out of favor.
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