Shining a Different Light on Fund Returns

Value Line has for decades been a respected name in stock research, but it remains a relative unknown in the mutual-fund-rating business.

Since launching a fund rating service five years ago to compete with that of Morningstar Inc. of Chicago, Value Line has struggled in its competitor’s shadows. Value Line won’t disclose the number of subscribers for its fund-rating publication and software, but it clearly trails Morningstar in visibility.

Steve Savage is trying to change that. He’s the 37-year-old executive director of the Value Line Mutual Fund Survey and executive director of the company’s electronic publishing operation.

A native of upstate New York who earned an English degree at Hunter College in 1983, Savage broke into the financial business as a writer for the Money Reporter investment newsletter. He then moved to CDA Wiesenberger, a fund-monitoring firm for which he helped to build a computerized operation.

He joined Value Line in 1993, and now heads a staff of 35, including about 20 fund analysts.

Savage, based in New York, was interviewed by Russ Wiles, a mutual fund columnist for The Times.

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Times: Let’s talk first about the Value Line stock rating service, for readers who may not be familiar with it. Your rating of individual stocks on a scale of 1 to 5 far predates Morningstar’s creation of its 1-to-5 mutual fund rating service.

Savage: Value Line’s stock research is unique in that we organize all of our investment information onto a single page. That’s the format the company was built on.

People don’t realize that Value Line, with coverage of 1,650 stocks, follows about 50% more companies than even Merrill Lynch. To our knowledge, nobody else comes close to providing the depth of research on such a broad universe of companies as we do.

Our analyst commentaries are unique, and we perform a series of earnings estimates for each company to determine whether that stock might be a good choice for appreciation.

And we have a “timeliness” ranking system, which has been audited and verified countless times by academics and by the Hulbert Financial Digest. Our track record has been superb.

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Times: What traits do your top-rated stocks tend to have?

Savage: Ours is a momentum-driven system. The factors incorporated into our model are earnings growth, earnings acceleration, stock-price momentum and various analyst estimates.

The stocks we rate “1,” or highest, have been performing well and tend to be higher-beta stocks [i.e., they are more volatile, up and down, than the market average].

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Times: So despite the name “Value Line,” your system doesn’t focus on bottom-fishing or bargain hunting in the classical sense for undervalued stocks?

Savage: No. It’s not a value system, although subscribers can find plenty of information to use in whatever way they like.

For example, our three- and five-year appreciation projections tend to be higher for companies that are undervalued now.

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Times: How often is the information updated?

Savage: Coverage is over a 13-week cycle. A new set of reports is issued each week, and the entire set is updated once a quarter, when the cycle begins again.

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Times: How do your roughly 70 stock researchers go about collecting information?

Savage: There’s a lot of number crunching to their jobs, in that they make a lot of adjustments to the financial data released by companies. Value Line is very highly regarded for its analyst training program. Many top professionals on Wall Street have, at one point in their careers, been analysts at Value Line.

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Times: Now let’s focus on your mutual fund service. As with stocks, you rank funds on a scale of 1 to 5, with 1 being the highest rating. But are the fund rankings supposed to predict the funds that will fare best going forward?

Savage: We do not claim that our ranking system is predictive. But it is useful because it gives you a quick measure of how a fund balances risk and reward relative to other funds within its group.

Morningstar describes its star ratings not as predictive but as a first cut. I disagree. I don’t think ratings should be viewed as a first cut. Your first cut should be to determine which types of funds you want and how you’re looking to combine them in a portfolio. Then the rankings become important because they can help you identify those that have done better within the various categories.

The biggest error I see is that people spend a disproportionate, even unreasonable, amount of time analyzing individual funds without considering how a fund might fit into an overall portfolio. A portfolio is not always the sum of its parts. It can be quite different. When you add a fund to a portfolio, its individual characteristics may become completely irrelevant.

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Times: A lot of investors may be confused by that. Can you explain?

Savage: For example, if a fund duplicates your other holdings, it might not exert much of an impact [on your total portfolio]. On the other hand, you can buy a fund whose risk and return numbers aren’t attractive on their own, but when added to your portfolio, it could give you a lot of benefit [relative to the rest of the portfolio].

You have to consider how a fund fits into your overall portfolio. Are you really diversified? Or are you just picking funds off Money magazine’s top-10 list, where all 10 funds are of the same type and made the list because they did the same thing? Adding funds from a top-10 list is a recipe for disappointment because the market cycle that put those funds on top is probably ready to turn, if it hasn’t already.

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Times: Is there an optimal number of funds to own?

Savage: Once you have made a basic assessment of the investment areas you want exposure to--foreign, large stock, small stocks, muni bonds or high-yield bonds, for example--you implement your approach by picking funds.

For most people, six to eight funds is enough to gain ample diversification. Once you get past, say, 15 funds, you have a broader portfolio than you can monitor effectively, and you’re not going to improve your performance by much.

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Times: Your overall fund ratings reflect risk-adjusted returns for five years, or for the life of the fund if it’s shorter than that. Morningstar’s overall rating looks at a combination of three, five and 10 years. Why do you favor five years only?

Savage: We back-tested the numbers and felt we couldn’t add much by including more than five years. Intuitively, that makes sense given the average fund manager’s tenure of less than five years.

Also, a fund’s style can shift dramatically over that time. In individual cases a longer record may be relevant, as with a manager like John Neff, who stayed on the job for 30 years [at Vanguard’s Windsor fund]. But when you’re applying one system to a broad group of funds, it makes more sense to apply a system that offers a good fit for all.

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Times: How do you adjust a fund’s returns for the risk it took to achieve those returns?

Savage: Our risk-adjusted rating makes use of standard deviation [how much a fund’s returns vary over time] and a proprietary measure we call “growth persistence,” which measures the consistency of positive relative performance.

So the more consistently that a fund outperforms its peers, the more it’s rewarded. But it’s not rewarded for the magnitude of outperformance.

So funds that may be all over the map [in performance] don’t benefit by beating their rivals by huge margins. In fact, they’ll be penalized for the amount of time they underperform. Ours is a risk-adjusted method that favors funds that are steady.

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Times: Individual funds frequently have different Value Line and Morningstar ratings. Would that mostly reflect the different measuring periods, your different risk-adjustment techniques or different ways to classify the same fund?

Savage: It’s most likely to be the different time period. We both rank funds within very broad groups [i.e., all domestic equity funds are lumped together for rating purposes, regardless of their investment focus].

Because we use five years and Morningstar uses a combination of three, five and 10 years, our rankings will be more sensitive to a fund’s recent performance.

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Times: Which features of fund coverage do you believe Value Line provides better than Morningstar?

Savage: I like our analyst-commentary format better because I know where to find the information that’s relevant, such as management style. Morningstar is more colorful [in its writing], admittedly. But sometimes it doesn’t get down to the nitty-gritty of what investors may be looking for. Our format is more clear-cut and direct.

We have other notable features, such as our market-cycle performance numbers and our measurement of results assuming both lump-sum investing and dollar-cost averaging. Most people invest over time, especially in the 401(k) world. Our dollar-cost-averaging feature shows how you would have fared by investing $10,000 initially, while adding $100 a month.

We also have some unique features in our software program. For example, you can do a portfolio stress test, where you create a portfolio, then find out what might happen to it if the market dropped 10% or whatever.

You also can create a grid that shows how each of your funds correlates to one another. It looks like those grids showing mileage distances between cities. If you have a lot of funds that are closely correlated in terms of performance, you can spot redundancies.

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Times: Value Line several months ago reduced its coverage of bond funds. Why?

Savage: We still track bond funds in our database, including performance updates. We just don’t issue full-page reports on them. We chose to apply our resources to covering the funds that we can add the most insight on--equity funds. With bond funds, the performance bandwidths are much narrower, and expenses take on greater significance.

We just think it’s more beneficial to our customers to follow 1,600 equity funds with full-page research and provide statistical data only on bond funds.

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ABOUT VALUE LINE

* Value Line was founded in 1931 by Arnold Bernhard and is a public company based in New York. It is now controlled by Jean Buttner, Bernhard’s daughter. The stock (ticker symbol: VALU) trades on Nasdaq. Monday close: $40.75

* Value Line Investment Survey, the company’s flagship stock research publication, covers 1,650 stocks. It counts 100,000 subscribers. Costs: $570 a year (print version), $595 (computer version). Trial subscription: $55.

* Value Line Mutual Fund Survey covers 1,600 funds. Costs: $295 a year (print version), $395 a year (computer version). Trial subscription: $49.

* The company also manages its own family of eight mutual funds. The largest fund, Value Line Leveraged Growth (assets: $421 million) gained 369% in the 10 years ended Sept. 30, versus 276% for the average U.S. general stock fund, according to Lipper Analytical.

* The company’s World Wide Web site: https://www.valueline.com. Phone: (800) 535-8760.

Source: Times research