Morningstar - Q1 2020 - 11

In Good Company
The Ownership Lens is
a strong predictor of
stock-fund performance.

The authors' secret: Rather than rank funds
by their past performances-which are unreliable
indicators at best, and outright unavailable
for funds that have new managers-they instead
evaluated their portfolios. Selecting mutual
funds by their portfolios, instead of their
performances, improves predictability. Does a fund
hold mostly good stocks, or duds?

held especially by managers with good past
performance, whereas Microsoft is held mostly by
managers with undistinguished records. It
seems reasonable to think that the first manager,
whose decision to hold Intel is shared by a
higher-caliber set of managers, has a superior
ability to select stocks, while the second manager,
whose decisions coincide with those of subpar
managers, has been merely fortunate."

Cleverly Done
IVORY TOWERS

John Rekenthaler

In 2005, three academics published a remarkable
paper. "Judging Fund Managers by the Company
They Keep," 1 by Randolph Cohen, Joshua
Coval, and Lubos Pastor, debuted a powerful
method of forecasting the future performance of
U.S. equity funds. When the authors sorted
funds by the paper's new measure, the bucket that
contained the lowest-decile funds recorded
the single lowest average future alpha, the bucket
with the second-lowest decile posted the
second-lowest alpha, and so forth. With one minor
exception, the pattern was unbroken.
The authors' alpha calculations were based
on Carhart's four-factor model, which adjusts for
investment style. Using the Carhart model
doesn't eliminate the possibility of an accidental
finding, but it addresses the most obvious issues,
such as the performance of small versus
large companies or growth versus value stocks.
The effect was almost too large to be believed,
except that the paper had been thoroughly vetted
and accepted by the leading academic publication
of its field, Journal of Finance. The strongest
version of the formula found that the top-decile
funds subsequently beat the bottom-decile
funds (again, as measured by Carhart alphas) by
an annualized 736 basis points. That is ... big.
For comparison, sorting funds by their expense
ratios or Morningstar Analyst Ratings leads to, at
most, a difference of 200 basis points.

Wait a moment, you may (and should) object:
Who is to say which stocks are best?
After all, if we knew that answer in advance,
we wouldn't need mutual funds. We
would simply buy the future winners, ignore the
also-rans, and short the losers.
The answer lies in the paper's title. The authors
wrote that they would judge fund managers
by the company that the managers kept, and that
is exactly what they did. The authors tested
each stock in a fund's portfolio to see what other
funds held that security. If the stock was
possessed mostly by funds that had excellent
track records, then it was scored highly. If,
on the other hand, the security was favored by
second- and third-rate funds, it received
a poor score.
The paper's calculation then averaged each
fund's individual stock scores, weighting
the securities by their importance to the portfolio-
that is, by counting a 5% position five times
more heavily than a 1% position. The single final
number represented the quality of the
actively run funds that had similar holdings.
The higher the number, the classier the
fund's cousins and, therefore, the better its
future performance.
The authors explain:
"For example, consider two managers with equally
impressive past returns, where one manager
currently keeps a big chunk of his portfolio in the
stock of Intel, while the other manager owns
mostly Microsoft. Suppose that Intel is currently

The paper's logic might convince academics,
but not many practitioners. "Judging Fund
Managers" has languished, presumably because
of its circuitous approach, as well as the
computational challenges. (The calculations
require complete portfolio holdings-far more
data than standard performance figures.) For those
reasons, and the fact that the paper hasn't
been updated, "Judging Fund Managers" hasn't
affected investor behavior. Despite the strength
of the paper's results, no investors to my
knowledge use its measure when selecting funds.
Morningstar's Update

That may change now that Morningstar's
quantitative team has duplicated the study
in a paper called "Morningstar Ownership Lens"
by Taylor Hess and Polaris Jhandi.2 It duplicated
the research from "Judging Fund Managers,"
but over the entirely different time frame of
2004-19 (the first paper covered 21 years ending
in 2002) and with a far larger fund universe.
Rather than assess only diversified U.S. equity
funds, sold within the U.S. marketplace,
Morningstar's study evaluated all equity funds
from across the globe. The professors' data
set concluded its final year, 2002, with 1,526 funds.
In contrast, when Morningstar's data set ended,
it contained almost 100,000 funds.
Morningstar's paper is an out-of-sample test,
to ascertain whether the authors' results
were robust. One couldn't ask for a stronger
experiment, with the time period in Morningstar's
paper completely new and the investment
universe greatly expanded. Nor could one ask for
stronger results.

1 Cohen, R.B., Coval, J.D., & Pastor, L. 2005. "Judging Fund Managers by the Company They Keep." Journal of Finance, Vol. 60, No. 3., P. 1057.
2 Hess, T. & Jhandi, P. 2019. "Morningstar Ownership Lens." Morningstar White Paper. Oct. 1.

morningstar.com/lp/magazine

http://www.morningstar.com/lp/magazine

Morningstar - Q1 2020

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