Mutual Fund Ratings Need Lots of Work

Morningstar and Lipper are the market leaders in mutual fund ratings, just as Standard and Poors, Moody's and Fitch are for credit ratings.  Their benchmarks for mutual fund ratings are widely used by sponsors and consultants for corporate defined contribution plans. 

Morningstar uses traditional MPT statistics in their evaluations, but the reports are still like beauty contests, formerly based on "stars" and now on a fuzzier system of "Gold," and "Silver."  Even funds which have mediocre performance and high expenses are not rated "Sell" or "Avoid."  In this way, the ratings have the same issue as sell-side equity research: too many 'buys" and few "sells."   For an illustrative example,  I want to focus on two well known funds with large asset bases, Fairholme and Sequoia.

Both of these funds have received accolades from Morningstar: Fariholme's founder and manager Bruce Berkowitz was named "Manager of the Decade," and Sequoia's co-managers Bob Goldfarb and David Poppe were named "Domestic Equity Managers of the Year for 2010." 

In the case of Fairholme, the meteoric rise in assets under management is well documented, but hard to understand. Fairholme created a catchy slogan for itself, "Ignore The Crowd."  It suggests a Warren Buffet-like value investing, or contrarian discipline. 

While Fairholme's assets were growing, I visited their website many times and even printed out the fund literature.  Besides the slogan, I couldn't understand what kind of analyst support was there for all the contrarian stock picks.  When Morningstar talks about the T. Rowe Price funds, by contrast, the Morningstar analysts often comment about the size of the analyst staff supporting the manager of a T Rowe fast-growing fund. 

Managing money, at the very root of the process, requires experienced, diligent, market savvy, financially and analytically sophisticated analysts who aren't afraid to challenge market valuations and assumptions.  Looking at Fidelity Management and Research, for example, the manager who oversees FMR's single biggest slug of assets with a long, consistent and distinguished track record is Will Danoff.  Will was Fidelity's retail sector analyst early in his career, when I called on him from the sell side.  Will Danoff, Rich Fentin and other portfolio managers who were former analysts, would always come to meetings with notebooks in which they had carefully recorded data from every previous interaction they had about a particular stock and about the company's management team.  You always had to be on your toes and remember your previous conversations with them, because they certainly did with those composition notebooks! 

Fairholme, by contrast, was always a black box.  Assets continued to pour in, the fund rode the market upward, and more assets followed.  Then came a series of peculiar investments, St. Joe, and Bank of America, which we have written about in earlier posts on this blog.  One of the funds periodic reports had a puff paragraph about St. Joe being a real estate play on the Florida Panhandle becoming the next Riviera, after a new international airport was built, on land adjacent to St. Joe holdings.  Sounds good, but it didn't pan out, and Bruce Berkowitz eventually became Chairman of St. Joe in a bizarre turn of events. 

Then, after saying that financial stocks were black boxes with poor disclosures and questionable asset valuations, Fairholme plunged into a large position in Bank of America.  What was this based on?  What changed in the philosophy towards megabanks?  This investment also culminated in a farcical conference call sponsored by Fairholme with the hapless Bank of America management.  The call was supposed to clear the air with Wall Street by allowing the skeptics to ask their toughest questions.  Nothing of the kind happened, and the stock went down right after the call. 

Soon after that, came the soap opera surrounding the departure of the mysterious Charles Fernandez, who was made co-manager of Fairholme Fund, director of the Fund, and President of the management company in 2008. I couldn't find anyone in the investment management business who knew anything about Fernandez.  This strange appointment raised no alarms among the fund rating companies.  In the fall of 2011, Mr. Fernandez left in more public, but equally mysterious circumstances to his arrival.  We'll stop here, but remember that through this long time period, Morningstar gives their rating of  Manager of the Decade to Mr. Berkowitz.

All the while, investors who rely on Morningstar got no insight into the people, processes, culture, analyst support, and compensation at Fairholme Funds.  However, reading analyst reports on other funds and fund families, those kinds of items were covered, to some extent.

Switching to the Sequoia Fund, the fund management company Ruane Cunniff Goldfarb has a long history, dating back to the predecessor company, Ruane Cunniff, co-founded by legendary value investor Bill Ruane, who I had the pleasure to meet and call on early in my career as an analyst.  The philosophy behind the Fund was, and remains, a Graham and Dodd, fundamental value approach.  Turnover is extremely low, which is beneficial both for trading expenses and for taxes. 

An interested investor, or an analyst at Morningstar or Lipper, could find decades of financial press and fund publications all telling an unchanging story about the approach and culture of the management company.  The importance of people, namely analysts, was always stressed.  Process was evident.  Sequoia had a long period of under performance relative to its peers, in the large value segment.  It held way too much cash for my tastes, something which I don't understand when you're collecting a healthy fee; its concentrated portfolio was dominated by holdings of both classes of Berkshire Hathaway. 

The bottom line is the fund continued to be managed according to its philosophy and beliefs.  Eventually, day-to-day management of the fund passed to Bob Goldfarb and David Poppe. Nothing changed.  However, when markets collapsed and valuations came in, the portfolio was transformed pretty dramatically.  Now the fund is classified as a Large Blend fund, because it has some growthy stocks in it, as opposed to down and out value plays.  People, process, philosophy, culture, analytical support, and compensation were all transparent and consistent.

I read carefully the published transcript of their Analyst Day, where the fund managers and analysts are made available to answer investor questions about their stock positions and anything else on the minds of the owners. An investor can count the number of analysts, learn their names and read about them speaking about valuation techniques and about the investment thesis for a stock they recommended. This transcript  is supplied by the management company, and so an owner doesn't have to mount a due diligence effort or rely solely on fund rating companies. 

 The fund rating companies seem to be putting out journalistic marketing pieces and are inconsistent in how they treat different funds.  There are no "Sells" in their research, which is something for which sell side equity research was castigated.  They can and should do a much better job.