Morningstar - Q1 2020 - 13

Morningstar's researchers recalculated the
Ownership Lens statistic every quarter
as new data arrived. The portfolios that they
created were always closely aligned
with the measure. In contrast, the funds owned
by actual investors, over time periods of
several years, will drift. Inevitably, the funds that
had the highest Ownership Lens scores will
regress toward the mean.
A Trial Run

Conducting a thorough test of how the
Ownership Lens statistic might be employed
in practice would be a very large effort-
far beyond the scope of this column. However,
Morningstar's researchers were generous
enough to provide me with the results for a single
time period. It ran from September 2016
through August 2019, covering diversified U.S.
equity funds. The conclusion was disappointing.
By and large, when implemented over
years rather than months, the usefulness of the
Ownership Lens disappeared.
Not entirely, it should be said. On average,
the U.S. equity funds that placed in the lowest two
quintiles for Ownership Lens scores as of
September 2016 subsequently posted three-year
total returns that were (very) slightly below
their category norms. Meanwhile, the top-quintile
funds outgained their Morningstar Category
averages by about 40 basis points per year. Thus,
favoring funds that had high Ownership Lens
scores did prove to be beneficial.
However, the benefit was weak, with no guarantee
that it would pay off for investors who formed
manageable portfolios. As it turned out, buying the
five funds that had the highest Ownership
Lens scores when the time period began would
have been profitable, as four of the five
subsequently posted good relative returns. But
selecting the top 10 or top 20 funds wouldn't
have been particularly successful. The
performance of those portfolios roughly matched
the category averages.
While much more work must be done before
a conclusion can be reached, indications
are that the Ownership Lens cannot stand alone
as a signal for intermediate- to long-term

equity-fund performance. The single experiment
that was run to test the measure's practicality
supported the suspicion that its effects diminish as
the investment holding period lengthens.
That is the bad news for using the Ownership Lens.
But there is also good news.
Two Is Better Than One

In their original Journal of Finance article,
the authors had the clever idea of reintroducing
a fund's performance history into the equation.
As previously stated, they viewed returns alone as
an untrustworthy indicator. However, they
reasoned, once the Ownership Lens scores were
determined, past performance might be
helpful in supplementing that measure. Good if
a fund had a top Ownership Lens score; better yet
if that fund also boasted excellent returns.
Yet another winning hypothesis! Adding
performance data to the Ownership Lens does
indeed improve predictability. When the
authors sorted funds into 5 by 5 grids, the highest
future returns for the 25 resulting groups
came from funds that had placed in the top
quintile for both Ownership Lens and
trailing risk-adjusted returns, while the lowest
returns came from funds that had landed in each
measure's bottom quartile.
The same pattern held for my single test. Adding
past performance rescued the usefulness
of the Ownership Lens measure by tripling the size
of the performance gap. Whereas half a
percentage point separated the future returns of
the top- and bottom-quintile funds when
the Ownership Lens statistic operated on its own,
the difference rose to almost 150 basis points
when using the double sort.
In summary, when combined with past
performance (and presumably also expense ratio),
the Ownership Lens appears to be a useful
screen for selecting mutual funds. Operational
difficulties prevent the measure from
showing its full power, but it remains strong
enough to be meaningful. K
John Rekenthaler is vice president of research
with Morningstar Research Services.

EU Prioritizes
Sustainable Investing
Policy shift is groundbreaking but uses
traditional approaches.

POLICY

Aron Szapiro and
Andy Pettit

The European Union is in the middle of a major
project to use financial markets to address
sustainability challenges-particularly global
warming. New legislation and directives
are in various phases of development. The
European Commission, the EU's executive branch,
proposed a set of new laws that would attempt
to elevate the environmental and social
sustainability of an enterprise as a key factor
for investors to consider.
Without question, this initiative is a massive shift
in the way governments have thought about
the need to regulate capital markets. Traditionally,
financial regulators focused on protecting
investors from fraud (and increasingly from
substandard or conflicted advice), ensuring that
financial markets are transparent, trading
is fair, and markets avoid systematically important
failures or liquidity crises. The EU's sustainability
project represents a sharp departure from
those historical concerns. Instead, the EU plans to
harness financial markets as part of a broader
policymaking agenda that promotes sustainability.
Indeed, the EU now has three goals beyond the
traditional regulatory concerns for financial
markets. It describes these goals as: 1) reorienting
capital flows toward a more sustainable
economy, 2) mainstreaming sustainability in risk
management; and 3) fostering transparency
and long-termism. In other words, the
EU wants to change Europe's investing culture. It

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