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Charles Schwab's advertising campaign for its new stock-rating system -- Schwab Equity Ratings -- is anything but coy. In the wake of lawsuits filed against stock analysts at Merrill Lynch and Salomon Smith Barney alleging conflicts of interest, the San Francisco-based brokerage firm has been pushing its ratings as the only objective source of investment advice on Wall Street. Hence the commercials in which a slimy brokerage chief tells employees "to put some lipstick on this pig" and sell a stock that they know is terrible because they have investment-banking business with the company.
Schwab's ratings are objective because they use only numbers -- earnings, valuations -- and not opinions to determine whether a stock deserves an A -- its best rating -- or an F -- its worst. But is the system a good stockpicker? Mutual-fund investors are about to find out. In June, 2002, the firm redubbed its Schwab Analytics Fund the Schwab Core Equity Fund and replaced its outside adviser, Symphony Asset Management, with an in-house management team that invests only in the firm's top-rated stocks. In addition, in August Schwab launched its Schwab Hedged Equity Fund, which emulates a hedge fund by buying A-rated stocks and shorting -- an investing technique that means profits when a stock declines -- stocks rated D or F (see BW Online, 8/15/02, "Hedged Bets, Small Players, Bigger Risk").
FIRST OF MANY? Because the new ratings have no track record, a lot is riding on the returns of Schwab's mutual funds. If they put up decent numbers, they should solidify Schwab's image as a provider of independent advice. "It shows conviction in their ratings system that they would put it to such a public test," says Dan Colluton, a Morningstar analyst who covers Schwab's funds. "I definitely expect them to roll out more of these ratings-based funds. They're going to try to make as much hay as possible while their competitors are cast in a negative spotlight."
Schwab's formula for the ratings -- which is proprietary -- consists of 24 different numerical variables, which the firm won't completely disclose. These variables fall into four categories -- Fundamentals, Valuation, Momentum, and Risk -- each of which receives a grade of A through F that, when combined, determine the overall grade.
Some of the variables in the Fundamental category include cash flow, earnings surprises, and operating efficiency. For Valuation, there are the familiar price-to-earnings, price-to-book, and price-to-cash flow ratios. Momentum includes the stock's price strength relative to the overall market and its earnings momentum, and Risk includes the stock's volatility and the stability of its revenue stream.
In all likelihood, the performance at Schwab Core Equity Fund will be at least average for a large-cap equity fund, because it won't stray much from its benchmark, the S&P 500. "We're trying to isolate as much as possible the value-added of good stock selection," says Jeffrey Lyons, who heads Schwab's asset-management division. "So we try to neutralize the effects of sector performance and capitalization on the portfolio relative to the benchmark." That means if the S&P 500 has 15% weightings in technology or health-care stocks, the fund will hold a 15% weighting -- and will try to keep its average stock capitalization in the same range as the index. Yet the fund will only hold top-rated stocks in those sectors and cap size.
LONG BIAS. As a result, if technology stocks suddenly rise, the fund should benefit from that at least as much as the S&P 500, and, hopefully, its better stock selection within the tech sector will give it an edge. But if technology keeps falling, the fund will suffer along with its benchmark. But the Schwab Hedged Equity Fund still may have an advantage. Since the fund not only bets for Schwab's top-rated stocks, but against its lowest rated ones, it could avoid broad market or sector declines. The only problem is the fund's typical short position is expected only to be about 20% to 30% of assets. That means the portfolio has a long bias and isn't completely hedged against declines.
Although mutual funds have legal restrictions as to the amount they can short, a number of competing funds do significantly more hedging than Schwab's. For instance, Boston Partners Long/Short Equity Fund is typically half long, half short, providing a lot more downside protection. So why Schwab's limited hedge? "We believe over the long term exposure to U.S. stocks is a good thing," says Lyons. "We didn't want to create a fund du jour -- a bear market fund -- just because investors are currently feeling skittish."
If Schwab's ratings prove to be accurate forecasters, a fully hedged fund would still work, even in a rising market. The shorts would rise less than the longs because the stock market would recognize the longs as better investments. The reason for the limited hedge may be the same as the reason why Core Equity Fund is sector neutral to the S&P 500. "If the fund's performance deviates too much from the S&P 500 and Schwab's ratings are proven wrong, the public relations impact will be negative for the company," says Rick Lake, chairman of Lake Partners, an investment advisory firm that specializes in hedged mutual funds.
"HEDGE FUND LITE." Indeed, Schwab Hedged Equity Fund will deviate only slightly in its sector weightings from the S&P 500 and it won't short sectors that it isn't also long. "We don't want a portfolio that's long sectors A, B, and C and short sectors D, E and F," says Robin Jackson, the fund's manager. As such, the fund really falls into what could be called the "hedge fund lite" category. It will have short positions to soften the blow of a market slide, but it won't differ enough from the benchmark to avoid a severe correction.
Schwab is charging hefty management fees for this fund. The fund's expense ratio is 2.22% of assets per year. That's significantly higher than the 1.44% ratio for the average domestic equity fund and more than double the 0.75% ratio of Schwab Core Equity Fund. Other hedged funds such as Boston Partners' fund and Axa Rosenberg Value Market Neutral Fund charge even higher fees than Schwab's, but they're completely hedged and really do perform differently from the stock market. "I find it hard to justify owning any fund that charges an expense ratio of more than 2%," says Morningstar's Culloton.
Especially if you consider that a computerized ranking system is doing all of the stockpicking. After all, how much does it cost to run a computer?
Lewis Braham is personal finance department editor for BusinessWeek in New York Edited by Beth Belton
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Copyright 2002, by The McGraw-Hill Companies Inc. All rights reserved.
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