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Joel Greenblatt Has A Big Secret For You...

|Includes: AAPL, Exxon Mobil Corporation (XOM)

The past few weeks have seen Joel Greenblatt, the father of Magic Formula Investing (NASDAQ:MFI), out promoting his new book released Tuesday, titled The Big Secret for the Small Investor. MagicDiligence is in the process of reading the book, and a full review should be up as early as next week.

From Greenblatt's interview with Morningstar, we already have a pretty good idea of what the book is about and the motivation behind it. The "big secret" is value weighted indexing. Most indexes, like the S&P 500 or Russell 3000, are weighted by market cap. That means that for every dollar you invest in them, the largest cap stocks get more pennies then the smaller cap stocks. For example, if you invest $100 in a S&P 500 index fund (SPY is a popular one), about $3.48 is invested in ExxonMobil (NYSE:XOM), the largest-cap stock in the index, while about $2.52 is invested in Apple (NASDAQ:AAPL), the second largest, and so on.

Greenblatt believes weighing the indexes by value parameters, such as the operating earnings yield and return on tangible capital used by MFI, produces better results. In the Morningstar interview, he says that market cap weighting removes about 2% of annual returns as opposed to equal weighting (where money is spread evenly among all stocks in an index). A quick Google search will net you dozens of studies corroborating that fact, and it makes intuitive sense as well - very large cap stocks have more limited growth avenues and are more appropriately priced, in general.

But the real upside is by placing bigger bets on firms in the index that rank higher by value parameters. Greenblatt contends that this adds 4-6% of return a year over market cap weighting, over the long term. Furthermore, back-testing shows that this method is not any riskier or volatile than a market cap weighted solution.

To implement this system for investors, Greenblatt and his partners at Formula Investing have created "managed indexed" mutual funds. The U.S.-based ones use a universe of the 1,400 largest U.S.-listed stocks and choose 800-1000 (FVVAX) or 75-120 (FNSAX) of the best ranked stocks by MFI parameters, rebalancing very frequently (daily, I believe). There are also international variants of these two funds, choosing stocks in 26 countries outside of the U.S.

These funds look like a good solution for hands-off investors to enjoy the benefits of the Magic Formula Investing strategy without requiring much effort. It also provides a nice benchmark to see, once and for all, if MFI really does perform in practice like Greenblatt contends in his back-testing studies.

Still, there 2 significant drawbacks to the mutual fund path, and adherents to MFI will definitely want to consider them before moving out of the classic strategy defined in The Little Book That Still Beats the Market:

1) Convenience Costs

Like all mutual funds, Formula Investing's funds charge management fees and a back-end load. The management fee for FVVAX is 1.25%, which means each year 1.25% of your assets are deducted (it is 1.35% for FNSAX). These rates are about average in the mutual fund world. With a minimum investment of $10,000, the minimum fee is $125 a year. In reality, for most investors it will be several times that. Also, for withdrawals before 90 days of deposit, there is a 1% charge (known as a load).

2) The Best Performing MFI Stocks Are Left Out

Covering only the top 1,400 U.S.-listed stocks, the funds are setting about $1 billion in market cap as the minimum for consideration. The original MFI study considered the largest 3,500 companies - quite a difference. The Little Book made it very clear that the MFI strategy works best with small cap stocks. The performance using the entire 3,500 stocks (about a $50 million minimum market cap) was 30.8% annually from 1988-2004 (vs. the S&P's 12.4%), while using just the largest 1,000 stocks netted a 22.9% annual return. That's still quite good, but about 8% annually is lost by eliminating the small-cap names. That's significant - 8% compounded on a $10,000 initial investment is worth $37,000 over a 17 year period.

This is, by far, the largest issue with the funds, in my opinion. Small-cap stocks are where us little guys have a distinct advantage over big money.

Summing It Up

There is no question that a lot of folks interested in the benefits of MFI are not interested in doing the work to maintain their own portfolios, handle the tax records, and so forth. For these people, Formula Investing's funds make sense.

For those that do go this route, I would expect the smaller sampled fund (FNSAX) to provide the better returns. From the book, grouping the index into deciles produced a perfect stair-step pattern of performance, with decile #1 outperforming decile #2, and so on. Given this, it makes more sense to concentrate funds in the top deciles ranked by the MFI statistics. Sticking with FNSAX would place more of your money in the higher deciles than FVVAX, and likely more than offset the higher expense ratio.

For those that don't mind doing the work, sticking with the classic MFI strategy is probably more likely to generate better returns on average, given the lower cost and ability to buy the smaller MFI stocks that have provided the bulk of the strategy's impressive returns.