Fund rater draws fire for omitting the losers

ON THE MONEY

April 09, 2006|By GAIL MARKSJARVIS | GAIL MARKSJARVIS,TRIBUNE MEDIA SERVICES

It's a spat between true believers, a feud over index funds.

You wouldn't think kindred spirits would have such a beef with each other.

But to a group of financial planners known as the Zero Alpha Group, mutual fund researcher Morningstar Inc. simply isn't committed quite enough to their index fund cause.

It doesn't matter that Morningstar has long acknowledged that plain old index funds, over time, tend to wallop most funds that strut their stuff and employ high-priced stock-pickers to attract investors.

Nor does it matter that the firm has repeatedly done studies showing that the star performers of the investing world end up looking fairly mediocre once their luck wears off.

Instead, Rockford, Ill., financial planner Brent Brodeski claims that Morningstar routinely uses "distorted" data that masks how flawed most actively managed funds are and underplays how well investors would do if they simply chose cheap index funds.

The spat revolves around "dead" funds. When Morningstar reports how groups of mutual funds have performed on average over the years, it leaves those disastrous funds out of its calculations. As a result, when it states how the average actively managed mutual fund, with a stock-picker at the helm, has enriched investors, the investing pros look better than they actually are.

Brodeski and financial planner Amy Barrett analyzed Morningstar's data from 1995 to 2004, and calculated how funds with active fund managers would have performed on average if the dead funds had been included.

Their finding: The average returns reported by Morningstar are 1.6 percent higher per year than they should be.

Further, Brodeski claims he found no evidence of an oft-recited theory: that spending extra for a large-cap fund might not be warranted, but that stock-pickers, on average, outshine the indexes when it comes to selecting small-company stocks and international stocks.

In fact, said Brodeski, the indexes win in large-cap, small-cap, mid-cap and international stocks, plus growth and value, when the failed funds are figured back into the data. And he said he found that especially important among aggressive small-cap growth funds, which suffered a tremendous fatality rate during the period that included the bursting tech bubble.

Don Phillips, managing director for Morningstar, doesn't disagree that leaving dead funds out of the data skews the averages.

He says Morningstar knowingly reports the data the way it does with one objective in mind: Investors aren't picking through a mutual fund cemetery when selecting funds. They are picking through the survivors. So the database focuses on the funds that are still being sold.

That said, he acknowledges that investors must be on their toes.

For investors, the key is to make sure they are getting what they are paying for because many funds charge high fees and over five or 10 years give investors weaker returns than they'd get with a cheaper index fund.

gmarksjarvis@tribune.com

Messages for Gail MarksJarvis also can be left at 312-222-4264.

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