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Careful What You Wish For

What appear to be good qualities in a mutual fund manager often can be detrimental to shareholders.

Jeffrey Ptak, 07/07/2011

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.

Management fees are another example. Fund companies have tended to opt for flat management fees and eschewed performance-based management fees that vary based on the fund's performance versus a specified benchmark. Why? One of the commonly cited reasons is complexity: A performance-based fee is said to be more difficult to administer and less predictable, as it can jump around based on relative performance.

But a thoughtfully constructed performance-based fee can more squarely align the manager's interests with those of fund investors, rewarding the fund for producing a good outcome and penalizing it when results fall short. Provided it measures the fund's performance over a long enough time period, a performance-based fee also helps ensure that management adheres to its long-term investment discipline.

A flat management fee courts another, less-cited risk: The manager is likelier to leave the fund open too long, as closing the fund would cap, or at least curtail, future revenue growth. Contrast that with a fund that levies a meaningful performance-based adjustment, in which case the manager can continue to reap rewards, even if he has closed the fund's doors. That's a key difference, as it helps mitigate the risk of "asset bloat" setting in, thereby preserving the manager's ability to effectively execute his strategy in the future.

While NTF funds are unavoidable in many circumstances, we try to be cognizant of a fund firm's overall distribution strategy, as this can yield insights into the competitiveness of the firm's current and future expenses. For example, while it's becoming rarer to find fund companies that bypass the NTF platforms altogether, we would generally expect such funds to be cheaper, as they're less likely to be saddled with 12b-1 fees.

With respect to performance-based fees, while we prefer funds that levy them, they're hard to find in practice. In cases where a fund levies a traditional flat fee with no performance adjustment, we're seeking reassurance that there are other mechanisms to align management's interests with ours as shareholders. For example, is management's compensation tied to performance? Do the managers eat their own cooking by investing alongside shareholders in the fund? Have the managers clearly articulated the fund's closing policy, or at least described the factors they'll consider in monitoring for asset bloat?PAGEBREAK

While it might not be apparent, we pay a price for easy entry to, and exit from, our investments. Academic research, including analysis produced by Morningstar affiliate Ibbotson Associates, suggests that investors in more-liquid fare, such as publicly traded stocks or highly tradable bonds, pay a premium. On the flip side, those who supply liquidity--either by selling those more-liquid investments or purchasing less-liquid securities--are able to command a premium.

Open-end mutual funds are, of course, daily liquidity products and, thus, must invest a significant portion of their assets in more-liquid assets in order to provide the access that investors crave. That is, they have to be able to quickly buy, and sell, investments in order to meet purchase and redemption requests, respectively. The upshot is that one could argue that fund investors are forgoing some return by the very nature of the liquid securities in which they invest.

Another oft-overlooked price of access is the cost of redemption activity that funds can incur. For example, a manager might keep some cash on hand in order to be able to meet daily redemptions in the normal course. This can be detrimental to the extent it keeps the manager from fully implementing the strategy, including putting money to work amid market distress (which is when redemptions typically spike). It also might make the manager less inclined to invest in controversial or misunderstood names, where the thesis takes time to play out.

Investors can, for example, tilt their portfolios toward less-liquid fare, which is more abundant among inexpensive and smaller names, or less-trafficked market segments. In addition, while we don't make a concerted effort to target "illiquid" managers, we're often drawn to value-oriented investors, some of whom take a contrarian tack. Since such managers are likelier to supply, rather than demand, liquidity, we believe it puts us on the right side of the liquidity continuum more often than not.

In areas that are inherently less liquid, such as municipal bonds, we'll take care to evaluate the manager's infrastructure and heft on the trading desk. What kind of access do they get to deals? Are they able to dictate structure and terms? How dependent are they on the sell-side? Not surprisingly, we find that scale is quite a bit more important in these areas, which informs our preference for institutional managers with deep resources and lengthy experience in the space.

With respect to redemption activity and the stresses it can cause managers, we pay close attention to the way the manager describes his process. Does he set expectations appropriately to warn investors that the fund could run hot and cold at times? Or that the fund is likely to invest its assets in areas that are deeply unpopular? Conditioning investors in this manner can help to stem redemptions, lessening the impact of asset sales, and ensuring that the manager abides by his stated investment discipline through thick and thin. We, of course, also applaud any preventive measures such as redemption fees that might prevent hot-money from pouring out of a fund, potentially interfering with investment management.PAGEBREAK

We all want to get a fair shake. When it comes to mutual funds, that means sharing ownership of the fund and, thus, a proportionate share of its gains, losses, and current income. Generally speaking, that's worked quite well, as investors have gained access to professional money-management irrespective of their lot in life. But funds also have to socialize certain types of expenses associated with the most trigger-happy sliver of the fund's shareholder base across all accounts; for example, trading costs and taxable distributions are spread across all of a fund's investors.

There are less-obvious side effects as well. For example, all shareholders have the same rights of entry and exit. Thus, a fund might have to meet redemptions by selling its most-liquid securities first, the remnants being the portfolio's harder-to-sell assets. This can be troublesome amid upheaval, when a fund might have to sell less-liquid assets at sharply reduced prices to simply meet redemptions, a process that can feed on itself. But it can also arise in garden-variety situations in which a fund has to meet a large redemption, which can punish remaining shareholders to the extent it exerts downward pressure on the prices of the securities that were sold. This can beget additional selling, pushing prices down some more and, thus, harming remaining shareholders.

To the extent possible, we'll examine the composition of a fund's shareholder base to assess its stability. Do a few large investors loom large? Did assets flow in gradually, or did "hot money" pour in over a short period? Are there factors that would make the asset-base stickier, such as proprietary demand?

We're likely to poke around the portfolio's holdings to evaluate the fund's ability to meet redemptions in the normal course. That'll entail calculating statistics like days-trading-volume in various stocks, which yields insights into how long or disruptive it could be for the manager to fund redemptions. In the case of bond managers, we're likely to probe the price-discovery process, including a fund's use of pricing services or reliance on intermediaries.

On the tax front, if a fund is carrying around a large embedded taxable gain, we'll try to determine whether it's concentrated in a few positions that can be avoided and if the fund has excess realized losses that it could apply against capital gains in the future.PAGEBREAK

To measure our return on investment, we must know two things--what the fund owns and the change in the value of those investments. This is only possible when those assets trade hands at readily ascertainable prices. Thus, accountability in the fund world demands transparent, accessible prices.

Sometimes, though, one has to wonder if we'd be better off just not knowing. Investors chronically over trade their portfolios, often on the basis of short-term returns, reflecting a basic human desire to understand how they're doing and compare with the alternatives. This behavior can reverberate widely. For example, seeing assets slosh around, a portfolio manager might be more inclined to shorten his time horizon to bag a quick gain. But managers who try to appeal to the lowest-common-denominator in this fashion can end up short-changing all of their shareholders, including those who are investing for the long haul.

Many fund managers react to the very same stimuli as their shareholders, zipping in and out of securities, with changes in observable price being the catalyst. Wouldn't fund managers also be better off simply not knowing? Paradoxically, research suggests many would. For example, "before and after" studies of funds--in which one compares the return of a frozen-in-time snapshot of a fund's portfolio with the fund's actual subsequent performance--finds that "before" trumps "after" to a surprising extent.

All things being equal, we'd prefer that our managers trade as infrequently as possible. Not only does it minimize transactions costs, but it also tends to denote other qualities that we prize, such as patience, rigorous research, and unwavering discipline.

A manager who hugs his benchmark often does so in bowing to short-term concerns--a fear of lagging the index over a quarter or one-year period. Further, he might over transact in the misbegotten belief that such trades will make up for the lack of conviction in other respects. If we see signs that a manager is willing to go his own way, it gives us greater comfort that he's unwilling to let the lowest common denominator--that is, investors' tendency to benchmark funds based on short-term performance--dictate portfolio management

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