For investment nerds, the recent Wall Street Journal article The Morningstar Mirage was high drama. The subtitle got straight to the point:

Investors everywhere think a 5-star rating from Morningstar means a mutual fund will be a top performer—it doesn’t.

Morningstar ratings mainly reflect past performance. However, something called “mean reversion” usually happens. If a fund has done well recently, it will have a high rating. But it usually doesn’t stick. The WSJ has a good visual:

This quote is spot on: “Morningstar’s star ratings for funds are clearly used in the industry to imply that funds that performed well in the past will do so in the future.” Check out the fund flows into the Permanent Portfolio Fund when they were 5-star. Just a couple years later, chheck out the fund flows out when they drop to 1-star.

Morningstar responded with Setting the Record Straight on Our Fund Ratings, which in my opinion just repeated the top graphic above. People think the left part will hold. Reality is the right part.

The Journal’s analysis found that most five-star funds perform somewhat better than lower-rated ones, yet on the average, five-star funds eventually turn into merely ordinary performers.

More importantly, something was conspicuously missing from this rebuttal…

Expense ratios are a more dependable predictor of performance. Source: Morningstar. Back in 2010, Russell Kinnell of M* had what the NY Times called “an act of radical and admirable transparency” in his article How Expense Ratios and Star Ratings Predict Success. Here’s my 2010 post about it.

If there’s anything in the whole world of mutual funds that you can take to the bank, it’s that expense ratios help you make a better decision. In every single time period and data point tested, low-cost funds beat high-cost funds. […] Investors should make expense ratios a primary test in fund selection. They are still the most dependable predictor of performance.

Smart investors know about this article. Morningstar executives choose not to mention it. Why would they? They charge fund companies $10,000 a pop to brag about their 5-star ratings in ads.

This is where my pragmatic side kicks in. I like Morningstar overall. I’m glad they exist. You just have to pick what you consume carefully.

• Morningstar creates a lot of high-quality, free stuff for DIY investors. They have great free data, some nice tools, and many helpful articles from knowledgable authors. I link to them regularly. I talk about star ratings never.
• People love star ratings systems. There’s a reason why you see stars on every Amazon product page. Most people don’t want to filter out everything themselves. They want the feeling that some fancy algorithm has hand-picked the best funds for them. They want easy.
• Financial advisors love star ratings systems. If the financial advisor makes a pick and it goes bad, then whose fault is it? Not mine, I followed the rating system and followed the experts! Financial advisors are incentivized to stay close to the pack, as if they stick out in the wrong way, they will get fired. This is known as minimizing career risk.
• This is not a perfect analogy, but Morningstar is kind of like Whole Foods. You could make some great food at decent prices using their raw ingredients and 365 product line. But 1/3rd of the store is prepared foods, and the most popular are stuff like pizza, sushi, mac & cheese, chicken nuggets, and chicken wings. Why do they sell these things? It is what the customer wants, and they are a for-profit corporation.

10 years from now, I predict that the system will be exactly the same. Morningstar wants to keep it, most clients want to keep it, and the financial advisors want to keep it. Morningstar stock plunged when the WSJ story broke, but recently bounced back up. I suspect people came to the same conclusion as I did.

Bottom line. The WSJ article reminds us of an important lesson. Morningstar “5-star ratings” are simply markers of past performance. Reversion to the mean usually happens. Consider long-term past performance as one factor amongst many, but don’t chase 5-star funds. Expense ratios are a better predictor of future returns than M* star ratings. If anything, simply avoid 1-star funds.

In early October 2007, the S&P 500 index hit just over 1,500 – an all-time high. You might have been concerned, or you might not have even noticed. Less than 2 years later, the financial crisis occurred and the S&P 500 dropped 50% down to 750 (March 2009). If you were a lump-sum investor, October 2007 would have been the worse month to invest in a rather long time. However, consider this chart via Bloomberg article:

If you held on through the panic, you broke back even some time in mid-2012 if you include dividends (total return). Four years after hitting bottom, you were again hitting an all-time high. After that, basically all of 2013 was spent reaching new “all-time highs” over and over again. You might have gotten nervous again. Is it time for another drop?

Yet, if you continued to hold on until now (October 2017), even if you had the worst possible timing an pushed all your chips in on October 2007, you would have doubled your money. Over the last 10 years, even after both pushing your chips in at an all-time high and experiencing a 50% drop, you would still have earned over a 7% compounded return.

You could interpret this as pro-stocks, but my takeaway is instead that all-time highs don’t mean much. The price could drop by 50%. The price could go up 100%. We’ve seen that, and thus should be prepared for both. Instead of worrying, try considering either possibility and make a plan.

If stocks keep going up from here, I will ______. If stocks drop 50% from here, I will _______.

In my case, my portfolio could be described roughly as 67% stocks and 33% bonds. If all my stocks dropped 50% and my bonds held steady, then I would end up at 50% stocks and 50% bonds. After a 50% haircut, I would be shaken but hopefully remind myself that stock valuations would look a lot better as well. If I can get up the courage, then I will rebalance back to 67/33. If I turn out to be a scaredy-pants, simply staying at 50/50 should still keep me adequately exposed to any recovery.

Do you think you’re a below-average driver? I didn’t think so. In the same vein, Jason Zweig had a funny tweet the other day that hit home:

Admit it: You do it, too.https://t.co/DaI0DON3XK pic.twitter.com/S9F3ILMiNz

— Jason Zweig (@jasonzweigwsj) October 2, 2017

His linked article ends with this advice:

Put 90% of your money in low-cost index funds and lock yourself in by adding a fixed amount every month through an electronic transfer from your bank. […] Speculate with just the remaining 10%, and use a checklist of buying criteria to make sure you never buy a stock purely because it has been going up.

This coincided with me reading stuff about the Kelly Criterion, a mathematical formula used to determine the optimal size of a series of bets. Basically, the greater your “edge”, the greater your bet size should be. If you have zero edge, then you should bet nothing. If you have negative edge, you should theoretically bet against yourself (if only casinos allowed that).

Here’s an interesting example that involved a special coin where you have the advance knowledge that it has a 60% chance of heads and 40% chance of tails. In short, with this edge you should consistently bet 20% of your bankroll each time. That’s it! If the coin was 52.5% heads/47.5% tails, you should only bet 5% of your bankroll. Most people do not find this intuitive.

What’s your own edge? Consider that some folks think that only 5% of Active Investment Managers Will Add Value. This is where I insert a couple of Charlie Munger quotes:

I think it is roughly right that the market is efficient, which makes it very hard to beat merely by being an intelligent investor. But I don’t think it’s totally efficient at all. And the difference between being totally efficient and somewhat efficient leaves an enormous opportunity for people like us to get these unusual records. It’s efficient enough, so it’s hard to have a great investment record. But it’s by no means impossible. Nor is it something that only a very few people can do. The top three or four percent of the investment management world will do fine.

If you stop to think about it, civilized man has always had soothsayers, shamans, faith healers, and God knows what all. The stock picking industry is four or five percent super rational, disciplined people, and the rest of them are like faith healers or shamans. And that’s just the way it is, I’m afraid. It’s nice that they keep an image of being constructive, sensible people when they’re really would-be faith healers. It keeps their self respect up.

Bottom line. In stock market investing, most of us lack an edge and thus should stick with index funds. But we all like to think we have some edge, so maybe a 5% or 10% fun money allocation is acceptable. Anything higher would be claiming to have some crazy, unreasonable edge. I would say it also depends on how aggressively your fun money is managed. Berkshire Hathaway stock is relatively low risk. Mine is invested in short-term loans backed by real estate with conservative loan-to-value ratios and a target return of 7%. The latest cryptocurrency promoted by celebrities on social media? Not low risk.

Vanguard has been sucking up assets like a vacuum, with total assets now exceeding $4 trillion. Their hybrid robo-advisor Vanguard Personal Advisor Services has over $65 billion in assets under management. Are they unbeatable? People tend to love building things up, then love tearing it down.

Vanguard holds the majority of my net worth, grown over 15 years in Vanguard brokerage accounts and Vanguard mutual funds/ETFs. You could therefore call me a fanboy, but also a concerned “client-owner” (I prefer the term “investor-owner”). As they keep hounding me to vote on their proxy, here’s what I like the most and least about Vanguard:

Pros

• Historical track record. Vanguard has a long history of providing investments at a low cost. When they arrive to an asset class, costs tend to drop like a rock. This the Vanguard Effect.
• Skill and experience. They are good at what they do – run low-cost index funds and low-cost actively-managed funds. They understand things like reducing index tracking error and utilizing securities lending to boost fund returns.
• Ownership structure. Vanguard does have a unique ownership structure conducive to continuing to maintaining low costs. There are no outside shareholders or activist hedge funds working to squeeze out every last drop of profit.
• Profitable. Vanguard has their current expense ratios and is actually making money (or technically breaking even) on every single fund and ETF. The others are losing money on their “cheap” products while they try to make money elsewhere.
• Less company risk. All the above adds up to my opinion that Vanguard has the best chance of future, ongoing lower costs. A potential cost beyond expense ratios that should be considered is the cost of switching to a different fund in a taxable account. If I sell now to buy something else, I will have to pay taxes on a significant amount of capital gains. I want to minimize the chance of having to do that.

Cons

• Lack of transparency on marketing costs. Vanguard runs a lot more advertising than they used to. I might argue too much, but nobody knows how much they are spending because they don’t disclose this even to their “investor-owners”. Vanguard is not a non-profit, but I have seen even non-profits suffer from internal bloat and having quality suffer in the pursuit of growth.
• Lack of transparency on executive compensation. Vanguard may not have outside shareholders, but we also don’t know how much money the CEO or other executives make. If Vanguard were a publicly-traded company like Schwab, they would have to disclose these numbers. As “investor-owners”, I don’t get told anything. As this Bloomberg article states, “Vanguard is an important shareholder voice on executive pay, but it isn’t transparent on its own compensation.”
• Mediocre customer service. Vanguard has struggled with the quality and responsiveness of their customer service as they have grown in size. My interactions with Fidelity and Schwab have consistently produced faster response times and more accurate levels of service. Vanguard themselves have admitted that they have had struggles in this area.
• Not necessarily the cheapest at any given moment. If you look at any specific ETF benchmark at any specific moment in time these days, the cheapest offering might come from Vanguard, but it just as likely might come from Schwab, iShares, or Fidelity.

Financial author Jonathan Clements argues in his Protection Money article that he is willing to a little bit more for Vanguard ETFs in order to avoid potentially having to pay significant capital gains if the loss-leader pricing trend stops. I think that is a very valid argument.

Now, you could also buy Vanguard ETFs inside another brokerage account. However, you may have to contend with trade commissions. A few exceptions on ETFs: Merrill Edge and Bank of America will give you 30 free trades a month if you have $50,000 in combined assets at BofA and Merrill (plus better credit card rewards). The Robinhood app lets anyone invest with free commissions (although I’d expect even less than Vanguard in terms of customer service). You can transfer Vanguard ETFs to another custodian for a flat fee if you wish to avoid realized capital gains.

Big picture. Vanguard changed the investment world, but now the gap is much narrower. I started out with Vanguard and think they still have the best long-term structure, so I own Vanguard mutual funds and ETFs. However, Schwab and iShares Core ETFs held somewhere with low trading costs and good customer service are also very good choices for someone starting out. This group of “nearly as good” alternatives to Vanguard continues to grow. Meanwhile, there is still another large group of “definitely worse” alternatives. Debating between 0.01% is rather useless when there are still people paying 1% or more for index funds.

Here are some updated thoughts on holding stocks based outside the US in your portfolio.

There is no “ideal” amount of international stocks that experts agree upon. You have numbers ranging from 0% (US only) to 50% (market-cap weighting). For a good summary of this situation, check out these two recent articles from Christine Benz and John Rekenthaler of Morningstar.

• Burning Questions for International Investors
• What Is the Right Amount of International Diversification?

The world continues to change, and the market weights will change with it. Here’s an interesting infographic by Jeff Desjardins at VisualCapitalist about world GDP breakdown for the last 2,000 years. The time axis is kind of wonky from 1-1900, so I’d focus on just 1900-now. GDP is not the same as market value, but the point is that the world will not look the same in 30 years.

Right now, in terms of valuation, US stocks are relatively expensive and International stocks are relatively cheap. Via this ETFTrends article by Chris Konstantinos at RiverFront Investment Group, via TRB:

Looking a 12-month forward P/E ratio at the MSCI All-Country World Ex-US index, we are currently at the largest valuation gap between US and non-US markets in the 15+ years of data to which we have access.

My take: Make a decission and stick with it. I don’t feel too strongly about this topic. If a Belgian company buys Budweiser, does that change how the business works fundamentally? If you go with 100% US stock and wait 30 years, you’ll probably be just fine. If you go with 50% US and 50% International and wait 30 years, you’ll probably be just fine. One choice will do better than the other, but nobody knows which one. These days I’ll be happy if we manage to avoid nuclear war.

I personally like buying a bigger haystack with all the needles and thus I like 50/50. If you want to hedge somewhere in between, consider that Vanguard Target and Lifecycle All-In-One funds are 60/40 now but they used to be 80/20 and then 70/30. It’s more important that you pick something and stick with it, as opposed to bailing out when one does a lot better than the other.

In terms of psychology, you can always twist the situation as needed. If you are 100% US, you could be happy with US outperformance over the last decade. If you are 50/50, you can take solace in the valuation gap and that any mean reversion from this point onwards will lead to future international outperformance.

In my personal portfolio, I’ve been investing in tax-exempt municipal bonds instead of treasury bonds due to their higher taxable-equivalent yields. If you’ve done the same, you may be interested to know that Larry Swedroe at Advisor Perspectives argues that the reason for this yield spread is not credit risk, but liquidity risk.

After the first month or so following issuance, most municipal bonds tend to trade very infrequently, perhaps once a month or even less frequently. Thus, they are illiquid. Since the financial crisis, banks have dramatically reduced assets committed to their bond-trading activities, decreasing liquidity in the municipal bond market. It shouldn’t be a surprise, then, that liquidity premiums have widened. The result is that municipal bond yields are higher than they would have been if liquidity had not been reduced.

Many investors can bear liquidity risk, because they buy individual bonds with the intent of holding them to maturity. For them liquidity is not a major risk, at least in some portion of their portfolio; the reduced liquidity in the market makes municipal bonds more attractive.

The spread itself has been narrowing, according the chart below tracking the ratio of AAA-rated GO Muni bonds to Treasuries over the last 12 months (not adjusted for taxes). Taken from the most recent Baird’s weekly muni commentary.

Still, muni bond funds remain relatively attractive for many folks, especially in higher tax brackets. Use this Vanguard taxable-equivalent yield calculator and compare the numbers for your own situation.

Bottom line. My takeaway is that muni investors should acknowledge this liquidity risk, and be prepared for short-term swings in muni bond fund prices (due to illiquidity) if there is a major event (like a surprise bankruptcy filing). However, if you are truly a long-term holder of muni bonds, then you can accept this risk, hopefully ride things out, and be compensated with higher tax-equivalent yields.