Marketocracy: Behind the Numbers

Posted on February 21, 2007

MarketocracyMutual Funds - We all use them and a lot of us rely on them for the bulk of our retirement savings but the percentage of us that know a lot about them is very small. In a prior life I worked in the mutual fund business and I thought that I would someday be a mutual fund manager before the entrepreneurial bug bit so I know a little bit about how the funds and the business of funds work. Needless to say I was very intrigued when I saw a piece on VentureBeat the other day about a newish fund/asset management group called Marketocracy.

The idea is a fairly simple one and one that has been tried before. Ken Kam, who co-managed the Firsthand Technology Value Fund in the bubble days (which was rated the no. 1 fund by Lipper - the defacto fund rating firm - for five years no less), thought that getting a lot of top minds (80,000 or so) together was the best way to pick a portfolio. Marketocracy was the vehicle for this. It allowed anyone to sign up on the web and manage a fund with a virtual $1mm. The best managers would then rise to the top and give Ken the ideas he needed for the Marketocracy Masters 100 fund (MOFQX).

The masters 100 fund has gone on to return 71% since inception (Nov 2001) which is a pretty good return. Now Marketocracy is even branching out into the managed accounts business ($10k minimum investment) where Ken will blend the four masters he just chose (i.e. best earning portfolios at marketocracy out of the 80,000) to achieve top returns for investors. Not bad, eh? I mean, who doesn’t want to earn 71% over 5 years in a mutual fund and possibly even more with the managed account? Answer: you.

Now, don’t get me wrong, I’m not saying that you shouldn’t want to make 71%. What I am saying is that it is not a great return relative to other similar funds. Not convinced? Let me prove it.

I’ve got the hook-up in the mutual funds biz so I had some Morningstar reports pulled on the Marketocracy masters 100 fund. What I was able to find was pretty surprising. The 71% return was correct and totally legitimate so that wasn’t the issue. The issue was with the beta and alpha of the portfolio (see Morningstar chart below).

The beta and alpha of the masters 100 fund relative to the S&P 500 are 1.69 and -6.28. The S&P has a beta of 1.0 so the fund is riskier than the S&P. Big deal - no risk, no reward right? Definitely. That’s where alpha comes in.

Alpha measures the relative risk of the fund as compared to the market (S&P 500 in this case). A negative alpha means that the fund did not achieve returns large enough to justify the risk taken. As you can see, the alpha of the masters 100 fund is pretty darn low meaning that the risk was far too high for the returns achieved. Basically, if you were invested in the masters 100 fund you took a lot of extra risk that you weren’t compensated for.

Ah, but what about the best fit index to the right, the Russell 2000 Growth? Good point. So, what Morningstar is saying is that the Russell 2000 Growth index is better aligned with the investment profile of the masters 100 fund. As you can see the numbers don’t look as bad. The beta is less than one so the masters 100 fund was less risky than the Russell 2000 Growth. However, the alpha is -1.41 meaning that the returns were still too low for the risk taken.

Now, I know the fund still made 71% so it wasn’t a bad place to be. However, there were similar funds to the masters 100 fund that did far better over the past five years. For example, there is a Fidelity fund in the same category as the masters 100 fund that did very well over the same period. How well? Check out the data below.

Holy cannoli! The Fidelity fund returned 246% in the same time frame that the masters 100 fund returned 71%. That’s a huge difference which is even more apparent when you check out the annualized returns also listed in the above graphic.

So, the moral of the story is to always dig. Sure, I would have been happy with a 71% return. However, I would have taken more risk than I needed to in order to achieve that return and there were some better options out there in the same category as the masters 100 fund.

In the end of the day the masters 100 fund has only proven to be an average performer so far. But, as the mutual fund lawyers say, past performance is no guarantee of future results (i.e. investors beware). Ken Kam is definitely a bright guy and a really good fund manager but he hasn’t leveraged the full power of the wisdom of the Marketocracy crowds just yet. I still think the idea has some merit (if you’ve got 80,000 virtual portfolios there are bound to be some great ones in there) and that it just needs to be executed well. Let’s see if Ken can make this idea pay for him, the investors in the marketocracy products and his investors (yup, he’s got some VC - $16mm to be exact - from US Venture Partners, Formative Venture Partners and some individuals).

Side note: Please don’t take this as official financial advice and get upset when things don’t pan out down the road.  Again, investor beware.

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2 Comments so far
  1. 4 Quick Things at Disruptive Thoughts March 6, 2007 6:13 am

    […] 1) A user-generated mutual fund returned 71% for investors. An interesting idea, a great return, and Eric shows us why it’s not attractive. […]

  2. Wayne the mutual fund guy January 27, 2008 8:58 pm

    Unfortunately convenience and the perception that some genius is going to invest their money wisely and make them rich at retirement are their reasons for investing in mutual funds. The fact is of course that management fees and poor management decisions usually make the returns mediocre at best and seldom beat inflation over the long haul. The perception of growth is just that, perception. The way CPI figures are manipulated the poor investor doesn’t realize until its too late that he could have put a list of stocks on a dart board and done better. And dollar cost averaging, well that’s another myth. There are some funds able to show good returns over short periods but the bigger they are the harder it is for them to exit during dowenturns.