Morningstar.com had a fantastic article that examines how the magic formula stacks up against Morningstar’s top-performing actively managed mutual funds. Morningstar first gained its reputation by examining the style and performance of mutual funds and comparing them against other similar funds. Since then, Morningstar has expanded its services by adding stocks, options, ETF’s, hedge funds, etc..The result? The magic formula bested the best fund by about 4.5%. This led Morningstar’s fund analyst John Coumarianos to state the following:

“It’s unreasonable to say that investors haven’t been served well by funds that have consistently added value over the index, but the formula’s performance makes me wonder about the value of professional management in the mutual fund format, though not exactly in the way that devoted indexers wonder about it.”

Powerful statements from a company founded by mutual funds. John does make a couple of fine points as to why mutual funds under perform the magic formula. First, he points out managers may be over thinking and placing too much confidence on their ability to predict future profits and discounting them. This is one of the reasons I stopped doing any form of discounting. Although I must admit, I have an excellent Excel sheet that I use that will automatically do a discounted cash flow, but I mainly use it to see a company’s numbers over a 10 year period.  Also included among the reasons for under performance is a mutual funds size and buying “legacy” portfolios which contain stocks that aren’t as cheap as they were when the manager first purchased them.  While legacy portfolios is something that cannot be avoided, a mutual fund’s size can be debated. As of March 23, individuals could screen for stocks with a market cap of 50 million and larger but can also screen for magic formula stocks larger than 5 Billion. The over 5 billion screen returns some well known companies that are large enough that any mutual fund could buy and sell without trouble. It also includes name that are not so well know. That necessarily is not a bad thing considering unknown stocks usually have a higher chance of being undervalued.

Finally, it’s tough not too like the magic formula. Its tailor made for individual investors and more importantly it makes sense.

The Morningstar article could be found by clicking here

Related posts:

1. Joel Greenblatt To Launch Value Based Mutual Funds
2. What Exactly Are Mutual Funds?
3. The Different Types Of Mutual Funds
4. Best IRA Mutual Funds
5. Magic Formula Mutual Fund