What appear to be good qualities in a mutual fund manager often can be detrimental to shareholders.
This article first appeared in the June/July 2011 issue of Morningstar Advisor magazine. Get your free subscription here.
At Morningstar Investment Services, we're big fans of mutual funds, which figure prominently in the portfolios that we build for our clients. They're transparent, giving us insights into a fund manager's thinking and facilitating portfolio construction; they're relatively simple to use; they put professional money management within our clients' reach at a reasonable price; and they're easy for us to monitor and measure.
The irony, though, is that these same qualities--transparency, simplicity, access, fairness, and accountability--can also impinge on how a fund manager makes investment decisions, sometimes to shareholders' detriment. In this piece, we explore the potential pitfalls associated with these traits and how the issues inform our approach to manager research and portfolio construction.
Though it might seem odd to knock a fund manager for being too transparent, we find there is such a thing as "too much information." Take, for example, the manager who plays the firebrand on the speakers' circuit, mincing few words and brooking no subtleties. Or the manager who, for lack of a better term, can't seem to keep his trap shut, spouting off at the market's every zig and zag. For this manager, there is no issue too inconsequential or insight too unmemorable to withhold from the world.
The problem? It can be more difficult for these managers to walk-back their views, or even to incorporate new information. Behavioral-finance wonks call this "anchoring"--these managers are more likely to get stuck. Building-block funds that invest in a specifically defined market segment, such as the stocks of midsize European companies, are another example of transparency run amok. In situations like these, the client's desire to construct portfolios brick by brick dictates the fund's mandate and, thus, investment decision-making, as the manager can't stray outside of the cordon that's been drawn around the fund. This can make managers more susceptible to relativism, where the "least bad" option is acceptable and capital preservation takes a backseat. By definition, managers of these funds also forgo opportunities that fall outside of the dotted lines that have been drawn around their portfolios.
While we want our managers to be articulate and have the courage of their convictions, it's also important that they avoid the kind of absolutism that leaves little room for maneuvering. For that reason, we scour shareholder letters and the "public record" to assess how nuanced a manager's views might have been and whether they've evolved over time. If we find, for example, that the manager is using media primarily to shill for himself and the firm he represents rather than present a contrarian view or illuminate some part of his decision-making process, we're far likelier to take a pass.
We're generally wary of funds that must operate within a very confining mandate. Instead, we've increasingly opted for more-flexible managers, some of whom invest across the capital structure. We think it's our managers' job to make decisions in a discerning way, consistent with their stated discipline, not to tiptoe around a somewhat arbitrary line that we've drawn. It's our job to take any of these funds' biases into account when building portfolios.
Clients generally crave simple solutions. No-Transaction-Fee (NTF) platforms are an example. NTF platforms can be a good fit for investors seeking a bevy of options in one place with few strings attached. But nearly all NTF funds levy 12b-1 fees. Moreover, because fund companies can only partially defray the cost of listing their funds on an NTF platform (using the 12b-1 fees they levy), they have to pay the rest out of pocket, that is, out of the fund's "management fee." The rub? Because the management fee must be uniform across share classes, the cost of listing a fund on an NTF platform can also seep into share classes that aren't listed on NTF platforms.