posted 04-28-2000 10:36 AM         

Every six months (or whenever), the fund has to disclose what its CURRENT holdings are. So, if a fund picks up a high flyer at the end of the period and dumps a loser, it looks to the untrained eye that the fund has been holding the winner for a while and hasn't held the loser. But, performance should reflect the movements of the stocks when they were held--ie. there is no benefits to the performance from picking up the high flyer.

Or, at the end of six months, do the funds have to disclose all the stocks they held and for how long during the period? That would be much more valuable information and might make window dressing useless.

posted 04-28-2000 10:28 AM         

quote:

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Originally posted by belgarion:
a lot of managers feel the need to do a lot of activity during the eleventh hour to make their portfolio look that much better. Any thoughts on this process? Does published fund performance reflect only single day's of activity rather than the entire time period?

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You're referring to the 'window dressing' that Tom described. I'm not sure exactly what you're asking. The fund's performance will reflect exactly what the fund the did (ex. if the fund held a lame stock for the first eleven weeks of the quarter and then sold it and bought a recent winner, the fund's results would be similar to that of the lame stock's. Window dressing doesn't improve the results (in fact, it probably hurts them), but investors who don't compare the performance to a benchmark index probably won't realize the trick.
Or perhaps you were asking something else?

posted 04-27-2000 11:16 AM         

All of that said, my philosophy makes chosing an active manager that much tougher. Morningstar's ratings are useful, but not in markets with clear trends, such as the tech market of the past five years. Holdings data provide a snapshot of how diversified the manager is and how true he or she is to their style. But, as Tom points out, holdings data are subject to window dressing, etc. The fund's turnover ratio is helpful. Does a manager buy a stock because he or she believes in it? Or, is the manager a momentum chaser, turning the portfolio more than once per year? Even the soundbites provided to the media can be helpful, if a manager is quoted often enough for you to get a sense of their philosophy. Ideally, I talk to the manager, or read some research written by him or her, to learn how they think. While that's not possible in most cases, it really can open up your eyes.

posted 04-27-2000 10:41 AM         

quote:

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Originally posted by belgarion:
I disagree with this section. I think alot of people who invest in mutual funds are people who don't have a lot of time to spend on investing, don't check their portfolio often, and like trusting that someone else is doing the job for them (the manager). I doubt some people even realize how it works, and they are fine with that. But if money manager are required to explain the reason behind every little trade, it almost forces the investor to become more active then they want to be, and may pull out altogether. I would almost say ignorance is bliss when it comes to mutual funds.

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posted 04-27-2000 10:14 AM         

> with regards to columnists - where is this data you are referring to that proves most columnists and reporters are wrong? It's a real easy thing to say without backing it up with any real info.
I agree with you on this one, the data on columnists' performance was a little thin. But I think Tom's point was that except for Kiplinger's, none of the other magazines make it easy to collect this performance data. I guess you could check out the new sites he mentions and do your own calculation if you're curious.

posted 04-27-2000 09:56 AM         

quote:

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Originally posted by canamger:
Dear Tom: You mentioned that one may write to you and request a copy of your stock selecting tools. May I do that now.
You surely verify the fact that there are so few heroes and so many plain people, even in investment profession.
Thank you, Gerald Lawrence

---

Gerald,
Thanks for your interest in my analyses. You can find them at: http://www.investorguide.com/MSFT.htm http://www.investorguide.com/CSCO.htm http://www.investorguide.com/SCH.htm http://www.investorguide.com/AMZN.htm http://www.investorguide.com/USRX.htm

Below are the dates on which the analyses were published, the closing prices on those days (split-adjusted: 3 for MSFT, 3 for SCH, 4 for CSCO, 3 for AMZN), the current price, and the percentage change.

A few notes:
- I actually bought each of these stocks, shortly after recommending them, for my own portfolio.
- On 2/26/97, COMS announced plans to purchase USRX for 1.75 shares of 3Com per USRX share. The calculation below assumes that the COMS shares were kept in the portfolio (the worst-case scenario... they actually weren't).
- The AMZN analysis was published before the company went public. As the updates section of that page indicates, I bought in on 5/22/97 at 16.25 (pre-split).
- A couple of the analyses indicate when I sold, but the rest don't. The exact performance of the portfolio would depend on whether the proceeds from those sales were used to add to the remaining positions or kept as cash. Also, the fact that each stock was purchased on a different day makes benchmarking the portfolio against an index more difficult. Hopefully the performance data below is sufficient.

posted 04-27-2000 09:07 AM         

And with regards to columnists - where is this data you are referring to that proves most columnists and reporters are wrong? It's a real easy thing to say without backing it up with any real info. Whether or not that is true, I do find it real easy to figure out which ones are good and which ones aren't on my own. First, most explain their picks and recommendations (or the stocks they say to stay away from). Second, the are unbiased, as most reporters are not allowed to own the stock they write about. Third, many of them who make yearly picks go over them after the year is done to talk about what they were right on and what they were wrong on and why. What's great about reporters is that they have the space to explain what they are talking about - and I don't know a single reporter who doesn't use all of his/her space. If there's one thing they love, it's lots of words (the opposite of analysts).

posted 04-26-2000 05:56 PM           

I was just on the Fidelity site and their intro page for beginners has a picture of Peter Lynch saying "Know what you own and know why you own it." http://personal100.fidelity.com/planning/investment/?ref=welcome

posted 04-26-2000 02:38 PM         

In part one of this essay (last week), I discussed how analysts as a group are not as good at stock picking as you might expect, provided some reasons for the underperformance, and reviewed some sites that are adding
accountability to analyst stock picking so that individual investors can differentiate between those who are worth listening to and those who aren't. This week, I'll look at two more groups of stock pickers: mutual fund managers and newspaper and magazine columnists. If you'd like to discuss what you read here with other investors (and me), please feel free to post your thoughts at http://www.investorville.com/ubb/Forum39/HTML/000002.html

Mutual Fund Managers

Current Level of Accountability:

Due to SEC reporting requirements, there is already a significant level of accountability in the mutual fund industry. Funds are required to publish fairly detailed performance and expense information, and this information is available through a lot of offline and online sources as well as from the funds themselves.

However, the numbers don't tell the full story. During an extended bull market such as the one we're currently in (or were in until a few weeks ago), a rising tide lifts all boats, and it's tough to tell whether it was the mutual fund manager's savvy or a few lucky picks that led to the fund's performance. Also, the performance alone doesn't tell an investor how much risk the manager took in chasing superior performance. One technique investors can use is to benchmark the fund's performance against the most relevant index, and while this is very useful, it still doesn't tell the investor whether a successful manager picked the right stock for the right reason or just got lucky. There are also rating services, the most well-known being Morningstar's, which factors in performance, risk, style, and expenses. All in all, such ratings provide a fairly accurate picture of the quality of a given mutual fund, and the fact that the highest-quality funds tend to subsequently get the largest inflow of cash from investors indicates that there is a fairly high degree of accountability in the mutual fund industry (assuming that investors aren't blindly following the rating systems).

On the downside, mutual fund managers almost never explain the rationale behind their trades. To publicize their funds, they do sometimes throw sound bites at a camera, but a single-sentence explanation is never sufficient to establish the merits of a recommendation (and one can only hope that the manager's decision to buy or sell was based on a more thorough analysis). In an era of instant information, mutual fund shareholders are probably the only type of investor who are systematically denied knowledge of their
holdings, having to wait up to six months to find out what their fund managers have been doing with their money. This is entirely legal, and there is some logic behind it. Mutual funds are all competing with each other, and their individual strategies are kept secret to prevent other funds from benefiting from them. Mutual funds also compete with individual investors... if you can pick winning stocks on your own, you're much less likely to enlist the aid of a mutual fund manager, who is charging you for the service. So some funds are probably reluctant to reveal their strategies for fear that you might learn from them. Unfortunately, another consequence of this secrecy is that individual investors aren't able to determine whether a successful fund manager was right for the right reasons or just happened to be right for the wrong reasons (in which case the fund's performance is not likely to be repeated).

While funds don't have to completely tip their hands, they are required to publish their holdings at least once every six months. This can be instructive to investors who want to get an idea of what basic strategy the mutual fund is pursuing, but it makes portfolio allocation much more difficult, since the investor doesn't know how much he/she is holding in each sector at any point in time. Furthermore, the partial disclosure causes a conflict of interest. Mutual fund shareholders often judge a fund not just by its performance, but also by its holdings, and the fund managers know this. In order to paint the best possible picture of the fund, some funds sell underperformers and buy outperformers right before the semi-annual snapshots are taken. This activity is so prevalent that it has earned its own term, "window dressing". The effect is sufficiently pronounced that some investors believe that stocks which have been rising will rise even more in late December and June (and those that have been falling will fall even more), as mutual funds dump their losers and buy recent winners to make their portfolios temporarily look better.

Of course, not every mutual fund succumbs to this conflict of interest, but due to insufficient disclosure it's virtually impossible to tell which do and which don't.

Performance:

The average actively managed equity mutual fund returns about 2% less per year to its shareholders than the stock market returns in general. In only four of the last 20 years did more than half of all general equity funds outperform the S&P 500. In recent years, their record has been even worse: about 80% percent of all general equity funds have failed to keep up with the S&P 500 in the past five years. In other words, a stock picking methodology based on throwing darts at a list of S&P 500 stocks could have been expected to outperform 80% of all equity mutual funds. (For more ugly numbers, check out http://www.fool.com/school/mutualfunds/performance/record.htm) I don't mean to imply that all mutual fund managers are poor stock pickers, since there are some who do a consistently great job (Peter Lynch, who used to manage Fidelity's Magellan Fund, immediately comes to mind). But as the above statistics imply, there are a lot who don't earn their keep.

Explanation for Performance:

Why aren't the professionals, as a group, able to do as well as a dart thrower? Just as with analysts, it's hard to blame it on a lack of intelligence, although that may be a partial explanation for some of them. The rest of the problem, as with analysts, is conflicts of interest. Since they are not compensated based on performance (as a hedge fund would be), for at least some of them the top priority is not to do as well as possible, but to avoid doing terribly at all costs. The easiest way to accomplish this is to overdiversify, and this is what many of them do. The average mutual fund has over 100 different stocks in its portfolio, and most have no more
than 1% or 2% in any single holding, even their favorites. With that much diversification, there's very little chance that their performance will deviate more than a few percentage points from the overall market. This
strategy virtually assures mediocrity. Another conflict of interest is the "window dressing" effect I mentioned in the previous section. This compels some managers to dump stocks which have recently fallen in favor of stocks which are currently hot, even if it doesn't otherwise make sense to do so. In addition to these conflicts of interest, there are other factors that weigh on their performance, such as the funds' need to maintain enough cash to handle share redemptions.

By and large, the mutual fund manager's goals are well-aligned with those of their shareholders: if the fund performs well, the fund will eventually grow larger, meaning the fund will be able to collect more in management fees. However, managers would have more of an incentive to maximize performance if their compensation was directly tied to performance, as hedge funds are. Also, one could argue that growing larger isn't necessarily good for a fund, since not all investment styles are ideally suited for 'bigness'; for example, small cap funds have considerable difficulty finding enough great small cap stocks to invest in as their assets balloon, which could have a negative impact on their performance.

Sites Working to Improve Things:

While twice a year is the minimum level of reporting required, some funds are reporting their holdings more often. Among the ten largest fund families, three (American Century, T. Rowe Price, and Franklin) report quarterly, and one (American Funds) reports monthly. In addition, most funds report their top ten holdings on a monthly basis, but without percentage breakdowns.

Several mutual funds are going a step further. Montgomery Asset Management recently launched a new line of Stock Solutions funds, whose holdings will be posted after a two-week delay, along with running commentary from the funds' managers. Firsthand Funds, IPS Funds, Munder Funds, and Rydex Funds also update their holdings on their web sites at least monthly, with a time delay.

Two upstart mutual funds are taking more radical steps to further increase accountability, in the hope that improved performance will result: MetaMarkets.com and StockJungle. MetaMarkets.com operates the OpenFund mutual fund, which publishes portfolio changes on its site, along with the rationale for the trades, as soon as they happen. It also asks for stock suggestions from site users (both account holders and anyone else who has an opinion). In fact, Don Luskin, OpenFund's portfolio manager, found out about one of his fund's better performers, New York venture capital firm Harris & Harris Group (HHGP), from a visitor to the site.

Similarly, StockJungle also operates mutual funds that publish portfolio changes on the site, along with the rationale for the trades, as soon as they happen. And like MetaMarkets.com, StockJungle also solicits suggestions from site visitors. But one of StockJungle's funds, the Community Intelligence Fund, goes one step further, by compensating the best visitors for their picks. Its Hot Hands program pays cash to the top amateur stock pickers each day. StockJungle CEO Michael Witz says the fund's managers receive 20 to 200 stock picks a day. (The only requirements are that the stock be traded on NYSE, NASDAQ or AMEX and have a market cap of at least $100 million.) With each pick, the fund's managers can see the person's past
record, which helps them separate the wheat from the chaff.

Some critics have argued that the openness and community spirit of these funds are nothing more than gimmicks. They argue that openness is a mistake, as a mutual fund that revealed its holdings and portfolio changes in real-time might be at a competitive disadvantage, both to other mutual funds that might learn from the moves and to individual investors who might decide to invest directly in the companies rather than through the fund. This would be especially true of a large fund that tended to spread its purchases and
sales over many trades spanning several days or more. In such cases, the initial trade might compel others to immediately hop on the bandwagon and drive the price up or down (called front-running), which would cost the fund money. But this could be worked around, for example by revealing multi-trade portfolio changes only after the trades were completed. I suspect that there are a lot of individual investors who would very much like to hand their money to a mutual fund manager who is willing to explain what he/she is doing with their money and why.

Similarly, one could make the case that community stock picking is a mistake, and that the decisions should be left to the experts rather than to individual investors. I'll explore this further in next week's installment; for now, I'll just point out that (a) these community funds get suggestions and ideas from individual investors, but the managers themselves still do the research and make the final decisions; and (b) as I mentioned before,
80% of the professionals (equity mutual fund managers) haven't been keeping up with the indices, so it's entirely possible that certain individual investors could do a better job.

One other issue critics raise is that if many mutual funds already resort to window dressing to impress investors twice a year, they would be even more inclined to cave in to popular opinion on a regular basis if their picks were public knowledge at all times. This is a very good point, and I suspect that some funds would succumb to this temptation if placed under the microscope. But I think that accountability will win in the end, as those funds that were willing to buck the trend when it made sense to do so would tend to outperform in the long run, and would be rewarded for sticking with their strategy.

I don't expect all (or even most) mutual funds to begin reporting their trades and rationale in real time, and I'm certainly not suggesting that they should be required to. But I hope that the few that do will become
sufficiently popular that those that don't will be at a competitive disadvantage in their efforts to persuade investors to hand over their money. I also expect most of them, even the giant fund families, to begin to report their holdings more than twice a year.

Magazines, Columnists, and Newsletters

Current Level of Accountability:

Next time you visit your local newsstand, count how many financial magazines DON'T have the cover story "Ten Stocks to Buy Now" (this will be faster than counting how many do). Which magazines are the best at compiling such lists? I don't know, but I wish I did. In the world of magazines and fee-based newsletters, there is currently not much accountability. Readers can record what columnists have said or search a site's archives and see if the columnists were right, but very few people do this because no one has been making it easy to gather the necessary information. Also, during an extended bull market like the one we've been in (at least until a few weeks ago), everyone's picks look good unless you specifically benchmark their performance against a relevant index over the same time period. But as with analysts, even if you look at what they said, columnists' pronouncements are usually so vague that it's tough to demonstrate that they were wrong. They use phrases the way politicians and palm readers do: it sounds like they're saying something, but if you try to pin them down later the statement dissolves in a cloud of ambiguity. Columnists go out on a limb with 'bold' predictions like "If you want to change the risk-reward characteristics of
your portfolio next year, small caps may be the ticket." (This is a real example, but I don't want to embarrass the author by citing the source.)

Fee-based newsletters have somewhat more accountability than magazine columnists. Specifically, the Hulbert Financial Digest is an offline service providing objective ratings of over 150 newsletters and the 500+ portfolios they recommend. While this is a valuable service, it is fee-based, so most investors don't have easy access to it. Fortunately, Hulbert occasionally publishes some of its rankings in magazines (e.g. http://www.forbes.com/forbes/00/0124/6502156tab2.htm), but not often enough for individual investors to be count on being able to use it consistently.

Performance:

Shouldn't the celebrity stock analysts who appear daily on CNBC and CNNfn have been able to warn us about the recent 25% drop in the Nasdaq before it happened, rather than telling us now how we should have seen it coming? Last week I happened to catch a few minutes of Stockpicking Friday (yes, CNBC devotes one day a week to the activity). A caller asked the guest which direction a particular stock was going to go next, and the CNBC commentator said "If we knew that, we'd be on a beach in Tahiti instead of sitting in this studio" or something to that effect. The guest was not amused, but the commentator was right on the money.

According to Hulbert Financial Digest and other sources, newsletters as a group consistently lag the indices, and that's before factoring in the subscription costs they charge. Similarly, investing magazines as a group do
not provide great stock picks. While there is no aggregate data I can cite, I did gather recommendations from several leading magazines and checked the performance of those picks. Some outperformed the S&P 500, some didn't, but on average they appeared to do about as well as a dart thrower. Some magazines made it easy for me to collect this information (e.g. http://www.kiplinger.com//magazine/archives/1999/portfolios.htm), and they do deserve credit for imposing some accountability on themselves and the pros they get the picks from. Other magazines made it more difficult to gather the performance data, and perhaps not coincidentally those tended to be the ones with the worst records.

Explanation for Performance:

Why isn't the performance of magazine columnists better than it is? The main reason is that magazines must emphasize quantity even if it means sacrificing quality. Back in late 1996 and early 1997, shortly after I launched InvestorGuide.com, my plan was to pick stocks and write up my research on them. I started choosing stocks I believed in but found that I had to research ten or more stocks before finding one worth recommending - meaning I would have time for little else. I picked a grand total of five stocks over a nine-month period (Cisco, Microsoft, U.S. Robotics (later acquired by 3Com), Amazon, and Charles Schwab) - in the spirit of accountability, I would like to publish their performance thus far but humility prevents me. If you're curious, email me and I'll send you the numbers, or you can use InvestorGuide's research tool to check for yourself). In nine months, I wasn't able to find as many great stocks to recommend as most columnists can find for a single article. Since individual investors don't have the tools they would need to differentiate between good and bad, they become drawn to quantity rather than quality.

A similar problem exists in the fee-based newsletter world, with the additional problem that the barriers to entry are low and so it doesn't take much to start publishing a newsletter. While some undoubtedly have investing ideas that are worth more than their subscriptions cost, many do not, and there's no free, easy way for investors to tell the two groups apart.

Sites Working to Improve Things:

A few magazines, newsletters and web sites publish their portfolios and track them so you can see how they're doing, but you have to trust them; there's no third party auditing the numbers. The Motley Fool pioneered the idea of stock picking accountability, by using real-money portfolios and announcing buys and sells before they happen, along with detailed explanations for those trades. (Unfortunately the jury's still out on whether it deserves commendation for its portfolio policies... http://www.forbes.com/forbes/98/0223/6104146a.htm seems to conclude that the Motley Fool's picks aren't nearly as good as they appear to be, as they have apparently simply stopped tracking some of their underperforming portfolios, including one that reportedly lost 50% in less than a year.)

An even more notorious example of inadequate accountability was the Beardstown Ladies. Remember them? Their claims that they had been racking up Buffett-sized returns of 23.4% a year, a feat they said any investor could copy, put their books on the bestseller list... until someone took a look at their records and discovered that they had in fact been underperforming the S&P 500. Fortunately, they fell into obscurity after this discovery. (for a full account, check out http://www.time.com/time/magazine/1998/dom/980330/business.jail_the_beards12.html). The fact that they fell off the bestseller list as soon as they were exposed implies that there is at least some accountability here; the fact that they were on the bestseller list at all means there isn't enough.

One web site working to increase stock picking accountability among columnists is the Reese Group, at http://www.reesegroup.com. The Reese Group reads all the leading magazines and newspapers and records what columnists say about specific stocks, so you can later check the performance to see which ones are best at stock picking. Unfortunately this is as much art as science, as some columnists are vague about their picks and pans, probably in order to fight such accountability. In those instances the Reese Group makes a judgment call in interpreting what the columnist was really saying. (If columnists don't want to run the risk that the Reese Group will misinterpret a pick for a pan or vice versa, perhaps they will feel sufficiently compelled to make their picks and pans explicit.) The Reese Group tracks whether you could have done better than investing in an index by listening to a particular magazine, column, author or analyst by acting on his/her advice at the close of the next business day after receiving the information. When I visited the Reese Group site, it appeared that some of the data had not been updated in quite awhile, but if the site becomes more popular I expect they'll be able to more actively maintain it.

Another site working to increase columnist accountability is BigTipper.com, which we also mentioned in last week's discussion of analysts. BigTipper.com provides a database of columnist picks and the returns on those stocks as well as an average return for each columnist. Unfortunately the site does not yet provide comparisons to benchmark indices, so almost everyone looks pretty good in a bull market and bad in a bear market.

Hopefully sites like the Reese Group and BigTipper.com will give magazines and columnists an incentive to emphasize quality over quantity when making stock recommendations. The effect will probably be more pronounced for specific columnists than for magazines, since magazines do a lot more than just pick stocks and since it's unlikely that any magazine will be consistently better than any other magazine at stock picking. Those few columnists who do show themselves to be superior stock pickers will be able to use the internet to develop a huge readership.

Also, some magazines are helping to increase accountability, by indicating whether the columnist has an affiliation with any of the companies mentioned which might bias what he/she has written. Some articles just say "The author may hold a long or short position in some of the companies mentioned", which isn't as helpful as a specific list, but it's a start. The practice isn't as common as it should be, but hopefully it will continue to become more prevalent.

In the area of fee-based newsletters, the Hulbert Financial Digest is already working on the accountability issue, but as I mentioned it's fee-based. I'd like to see Hulbert offer the service for free online, supported by advertising, but I don't expect it to happen. Perhaps a startup will do it instead.

Coming Next Week:

The third and final part of this essay will look at individual stock pickers, and a new breed of sites that are hoping to prove that some individual investors can outperform the so-called experts.

Discuss It

If you have any comments about this article, please feel free to share them with other readers by posting them at http://www.investorville.com/ubb/Forum39/HTML/000002.html
_____________________________________________________________________

posted 04-25-2000 07:27 PM         

STOP SELECTIVE DISCLOSURE? - The SEC is proposing to adopt Regulation FD, which would limit selective disclosure, the practice whereby companies release information to a select group of the public -typically analysts - without releasing it to the public at large. The proposed rule has received over 1,000 comments, which is extremely unusual, and is pitting large broker dealers against smaller broker dealers and the investing public.

We have been addressing the SEC's attack on whisper numbers and access to information by analysts for quite some time, in our Millennium column (http://www.seclaw.com/docs/12000millennium.htm), in Changing Times (http://www.seclaw.com/docs/200Changingtimes.htm)and in Levitt Concerned (http://www.seclaw.com/docs/400levittconcern.htm). The SEC has been making speeches about the proposed rule, and public comment is hot. So hot, that Motley Fool has gotten into the act and has launched an active campaign in favor of the rule.

The Motley Fool's active campaign starts at http://www.fool.com/specials/2000/sp000424sec.htm.The SEC's material regarding the rule starts with their press release, and has links to the relevant material by the SEC, starting at http://www.sec.gov/news/seledisc.htm. The response of the Securities Industry Association is at their site, http://www.sia.com/legal_regulatory/html/sec_regulation_fd_4-6.html.

The rule has far reaching effects, and actually attempts to broaden the definition of insider trading. So, whether you are in favor of the proposal or not, this might be the time to jump into the world of public comment. The comment period is only open until April 28, 2000, and comments can be submitted by email. To do so, email rule-comments@sec.gov and put "Proposed Regulation FD: File No. S7-31-99" in the comment header, and sign your name and company affiliation if any.

A special report from The Securities Law Home Page, http://www.seclaw.com, the online guide to the law of the securities markets since 1995.