Review: Fund Spy by Morningstar’s Russel Kinnel

The more I’ve read about investing, the more I’ve come to see picking actively managed mutual funds as an unproductive endeavor.

In the hope of finding some evidence to the contrary, I recently read Fund Spy: Morningstar’s Inside Secrets to Selecting Mutual Funds that Outperform by Russel Kinnel, Director of Mutual Fund Research at Morningstar.

In his book, Kinnel argues that the four things to look for when choosing a fund are:

• Low expense ratio,
• Low transaction costs,
• High investment of manager’s own capital, and
• Good stewardship of investor assets.

Look for Low Costs

Kinnel’s chapter explaining the importance of low expense ratios was nothing new, though I’m always happy to see an author mention the topic.

In the chapter on transaction costs, however, Kinnel points out something I was unaware of: Portfolio turnover only reflects the lesser of purchases or sales made by the fund, divided by the fund’s assets.

In other words, in some years, a fund’s portfolio turnover figure could be quite low even though the fund incurred a great deal of transaction costs. For example, if the fund had large cash inflows from investors, it probably incurred a great deal of “buy side” costs. But if it sold very few investments over the year, its portfolio turnover would still be very low.

So Kinnel suggests that rather than looking at portfolio turnover, we should look at estimates of transaction costs. Makes sense.

Unfortunately, I don’t know where to find such estimates. Kinnel seems to suggest that they’re available somewhere on Morningstar’s site, but try as I might, I can’t seem to find them.

Investment of Manager Capital

Kinnel suggests that investors look for funds run by managers who invest a large amount of their own money in the fund. That has a certain common sense appeal.

Unfortunately, Kinnel doesn’t provide any data supporting the idea that investment of manager capital is a successful predictor of fund performance. No references to relevant studies. No footnotes. No end notes. Nothing.

He does provide a list of the 40 largest fund companies, ranked by average investment of manager capital, thereby allowing you to find a general pattern that the better-performing companies are near the top and the worse-performing companies are near the bottom. But that’s hardly the data-backed reassurance I’d look for before implementing the strategy.

Good Stewardship

Kinnel argues that one of the most important steps in selecting a mutual fund is to find a fund manager and fund company who place fund investors’ interests ahead of fund management’s interests.

Interestingly, David Swenson makes exactly the same argument in Unconventional Success. Swenson argues that, because individual investors have no access to meaningful information about the character traits of fund managers, we’d do better to stick to index funds where it’s less of a concern.

In contrast, Kinnel suggests that we rely on Morningstar to collect the information for us. You see, Morningstar provides letter grades for stewardship. “Just look for the A and B funds and avoid the Ds and Fs,” Kinnel says.

But again, there’s no data. Nothing whatsoever indicating that these letter grades have proven useful for predicting fund performance.

What am I missing here?

Toward the end of the book, Kinnel provides an analysis of the largest fund companies. For example, he has the following to say about American Funds:

“I like all of American’s funds, so I won’t say there are any you should skip.”

I don’t get it. Why, for example, would I opt to buy American’s EuroPacific Growth Fund instead of Vanguard’s Developed Markets Index Fund? Regarding Kinnel’s factors for selecting funds, it would seem that the index fund wins by a mile.

• Its expense ratio is much lower (0.29% as opposed to 0.80%), and it has no sales load.
• As an index fund, I suspect it has lower transaction costs–though again, I can’t find Morningstar’s estimates.
• Given that Vanguard is owned by the investors in its funds, I have a hard time imagining how American could possibly beat it in terms of stewardship of investor assets.

I’ve only come up with two possible explanations so far:

1. Kinnel has some relevant information/data that, for some reason, he doesn’t include in the book–something supporting his recommendation of not-so-inexpensive funds, or
2. He understands that if the best method for picking funds is really just “choose the lowest-cost option,” there’s not much of a need for Morningstar.

I hope that #1 is the answer. But I’m left wondering: If there is some such data, why doesn’t he share it?

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