Monday, March 10, 2008

An idiot's equity market neutral fund: More on Morningstar rankings

I received a lot of feedback on my original post about a month ago entitled An idiot's equity market neutral fund, where I used Morningstar rankings to pick a series of mutual funds in order to produce an alpha. Much of the criticism centered around the use of Morningstar rankings. Numerous studies have shown that relying on Morningstar rankings alone did not produce positive excess returns and that they formed inefficient portfolios (for examples see here, here, here and here).

The key to success of the synthetic equity market neutral strategy's forecast alpha seems to be the change made in 2002 when Morningstar normalizated fund ranks within style groups. This effect was documented by a new study (Morey & Gottesman 2006). In addition, I picked relatively low cost funds with expense ratios < 1%, which should reduce any "headwind" in the process of alpha production.

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