Charles Schwab (SCH) is offering to put your money where its mouth is.
Schwab, which unveiled its "objective research" in May amid much fanfare, has announced it will apply its research to one of its mutual funds.
Schwab's $185 million, renamed
Core Equity Fund (formerly the Schwab Analytics Fund, which has been around since 1996) will hold about 150 large-cap stocks that have A and B ratings. A stock won't necessarily get the boot if its grade falls; however, managers will purchase only A and B stocks.
Schwab promised research coverage of stocks of the more than 3,500 companies whose market capitalization exceeds $75 million. The brokerage will provide a weekly screen for its customers based primarily on fundamental factors such as earnings and cash flow, but will also take into account Wall Street analyst upgrades and downgrades.
In Schwab's stock rankings, the top 10% earn A's, the bottom 10% warrant F's and the middle 40% merit a C. A-rated stocks are expected to strongly outperform the market over the next 12 months, while F-rated stocks are likely to greatly underperform the market.
This isn't the first time that a fund has been driven by a somewhat gimmicky stock ranking system.
created its proprietary Timeliness Ranking System in 1965, which focuses on earnings and price-momentum indicators. But though that firm boasts that "an investor who purchased all stocks rated No. 1 by Value Line at the start of each year since 1965 and sold them at the end of each year would have seen his/her investments appreciate more than 18,000% through the end of 1999," it was unable to replicate anything close to that sort of performance in its
Value Line fund. Indeed, the fund has lagged behind the
for the past seven years, and its annualized 10-year returns trail the S&P by 2.55 percentage points.
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"Academic studies don't usually take trading costs, bid/ask spreads and the like into account," says Morningstar analyst Pat Dorsey. "All those real-world costs can really eat into returns, even if the model seems to outperform."
Schwab's equity ratings appear to be derived from what's called a "factor-loaded" model, in which analysts look at previous years of stock data to determine what factors -- earnings surprises, industry attractiveness, relative strength and the like -- correlate with positive stock returns. The model then takes these factors into account in determining which stocks are likely to outperform in the future. Like Value Line, Schwab won't disclose the details of its model.
But using back-testing to determine future results rarely works in practice, says portfolio manager William Valentine. "It used to be that the Chicago Bears couldn't win on a Monday night," he says. "Passive emulation of a system derived from back-testing isn't going to give you real-world results."
Whether Schwab's revamped large-cap growth fund succeeds remains to be seen, and in the meantime, the actively managed fund probably won't undergo any changes solely based on the shift in mandate.
Nonetheless, the idea of exploiting its ranking system through a mutual fund has already shown its weakness. Five of its top 15 holdings --
-- get a C rating.