Value in Morningstar?

I’m sure most of you have heard of Morningstar Inc. (MORN), the fairly influencial investment advisory company most known for their mutual fund star ratings. These ratings, which rank mutual funds on a 1-5 scale with 5 stars being best, garner much attention and are constantly advertised in various fund company marketing materials. However, recent events once again should remind investors to be very wary of these types of endorsements.

According to SEC filings, Alberto Vilar and Gary Tanaka were removed as managers of the Amerindo Technology D Fund (ATCHX) last week after both men were arrested on federal charges of defrauding investors and stealing $5 million from their clients. As a result, Morningstar advised Amerindo Technology shareholders to sell earlier this week. “Charges of fraud against Amerindo Technology’s managers are just the most obvious reason to avoid it,” said analyst Dan Lefkovitz in a written report. “We’re worried that impending redemptions will only exacerbate the fund’s problems by forcing it to sell out of positions.”

Okay, it seems reasonable that Morningstar recommend such action given recent events, no doubt about that. My question is, why hadn’t they recommended investors in Amerindo sell before now? Morningstar had the fund rated “3 stars” before news of the arrests hit the wires. This rating equates to a “neutral” or “average” investment option. How can such a respected research firm think this fund was average?

Let’s look at some specifics. As of March 31st the fund held only 12 positions. That’s right, twelve. I’m going to go out on a limb and say that is the most concentrated mutual fund portfolio in the country, a huge red flag.

How about performance? After all, if these guys knew how to pick stocks, maybe 12 positions is acceptable, or at least warrant an “average” recommendation. Amerindo’s 5-year average annual return? Negative 20 percent. Now you don’t have to be a math or finance major to know that 5 years of 20 percent losses is going to leave you in quite a bit of a jam financially. In fact, you’ll lose two-thirds of your assets over that span with those types of returns.

To make matters worse, the fund was down another 22% through April 30th. Oh, and did I mentioned the 2.25% annual expense ratio? So we have a fund with 12 stocks, an expense ratio which is 50 percent above the industry average, and some of the worst 5-year returns of any fund in the country. Morningstar gives this fund 3 stars. I’d hate to see what a one or two star fund looks like.

In addition to much of the equity research out there today, it appears we can add Morningstar to the list of investment advisors who should probably carry less weight in our minds than they do. Interestingly, the company recently went public and the stock is up from an $18.50 offer price to a current quote of $27.65 per share. Hmmm, perhaps an interesting short candidate?