GURU and the Rise of Quality Holdings Research

Marketing Gurus

ETF and mutual funds have several ways to attract investors and their capital. They can offer low fees, a brand name institution, or an “index fund” that promises to track broad market performance. And they can offer big-name fund managers.

These offerings are designed to convince investors that they will receive a nice return when they put their capital in the hands of these funds – usually in the absence of a marketable performance track record.

If the past performance of the funds is good, then, by all means, the marketers will tout that. Indeed, the mutual fund rating world is built primarily on past performance. One of the great things about past performance is that there are many ways to make it look good. There are multiple measurement techniques and multiple time periods from which to take them.

However you slice past performance, it is far and away the most marketed piece of financial data.

Fund Investors Must Beware

What is not marketed is the evidence against the reliability of past performance. Numerous studies prove that past performance is not a reliable indicator of future performance. In fact, a recent study shows that good past performance is actually an indicator of future underperformance. I wonder if all the different ways a fund’s track record can be measured to look good is one of the reasons it is such a poor indicator of future performance. 

Whatever the reasons, investors rely on past performance heavily.   

Investing services like Morningstar helped create and perpetuate this undue reliance on track records. Easily one of the most recognizable brands and firms in the financial business, Morningstar’s research dictates the tastes and attitudes toward research of many, many advisors and investors. As I am sure you, dear reader, are aware, Morningstar’s fund and ETF ratings are based primarily on a fund’s past performance.

Per the evidence above, this rating system can mislead investors by linking a fund’s gains or losses in the past to its ability to generate returns in the future. And reliance on past performance makes investors susceptible to exploitation by fund marketers, many of whom pay Morningstar a fee for the right to advertise their Morningstar rating.

When I write “exploitation,” I refer to a recent study by Vanguard that many fund providers handcraft an index to show the best back-tested results while ignoring the potential future performance. In other words, the providers design the ETFs around good back-test scenarios and market the funds based on those good-looking back-test results This practice is great for marketing but bad for investors. The average back-tested index outperformed the market by 10.3% per year in the five years before an ETF’s launch, then underperformed by 1% a year in the first five years of the ETF’s existence.

Protection Against Marketing Propaganda

As articulated by George Siste in his recent MarketWatch article, “On Wall Street, business as usual thrives on investor ignorance. It is not in its interest to have more astute clients.”

Despite heavy propaganda to the contrary, low fees, index labels, celebrated managers and good track records cannot guarantee or drive a fund’s future performance.

The best way to maximize future returns is to hold the best stocks. And yet, where is the research on the quality of ETF and mutual fund holdings?

My firm operates on the belief that a fund’s performance is ultimately dependent on the quality of its holdings. That’s why our ratings of every ETF and mutual fund are based primarily on their portfolio management rating or the fundamental quality of their holdings. Barron’s agrees: investors need to be aware of the Danger Within.

Put another way, research on fund holdings is necessary due diligence because a mutual fund or ETF’s performance is only as good as its holdings’ performance. No matter how low a fund’s fees are, performance cannot be good if its holdings do not perform well.

Investors Like Funds Built Around Quality Holdings

The emergence and performance of the Global X Top Guru Holdings Index ETF (GURU) is a testament to this idea that a fund’s holdings are the only thing that drives future performance and ensure a quality investment. GURU follows the holdings of the leading hedge funds as revealed in their 13F filings every quarter, and adjusts its own holdings based on the “highest conviction” picks from low-turnover hedge funds.

The point here is that hedge fund managers spend many millions of dollars on analytical talent and tools to identify the best holdings while commanding equally high fees. GURU, however, tracks the holdings of the best of the best while charging investors low total annual costs of only 0.75%. What a novel idea: quality holdings at an affordable price.

GURU owes its existence to having access to the holdings of the “guru” portfolio managers. Investors are also beginning to realize that Wall Street will always have an investing advantage with its access to insider information and the latest market data. If you can’t beat them, GURU offers the chance to join them.

One of my favorite mutual funds is Sun America Focused Dividend Strategy Portfolio (FDSTX) with over $5.7 billion in assets. Seven out of FDSTX’s top ten holdings get my Attractive or Very Attractive rating, and the fund allocates over 70% of its holdings to Attractive or better rated stocks. FDSTX is not the cheapest fund, with total annual costs of 1.87%, but its portfolio full of good stocks helps it secure my Attractive rating, one of only 67 funds out of over 7000 mutual funds and ETFs to do so.

Much like FDSTX and its $5.7 billion in assets, GURU has begun to attract plenty of attention from investors due to the quality of its holdings. GURU has gone from total net assets of a few million at the beginning of this year to nearly $110 million today.

No Substitute for Diligence

GURU’s costs are not the lowest, nor does it have a big-name fund manager, and nor does it rely on its past performance to promise future gains. Rather, GURU’s selling point is the underlying quality of its holdings, vetted by the research divisions of the best hedge funds. As is evident from GURU’s growth, investors are practically jumping at the chance to buy into a fund that ensures the quality of its holdings above all else.

If this is true, and investors are realizing the importance of quality holdings in the popularity of funds like GURU, then shouldn’t all funds be judged by the same standard? I have a feeling there would be fewer four and five-star funds on Morningstar if this were the case. 

As mentioned before, a fund’s costs can be important, but a fund’s performance can only ever be as good as its holdings’ performance, and the quality of a fund’s holdings should drive all investment decisions. Investors deserve fund ratings that are firmly rooted in the quality of a fund’s holdings, and we are here to give it to them.

André Rouillard contributed to this article

Disclosure: David Trainer and André Rouillard receive no compensation to write about any specific stock, sector, or theme.

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