Christine Benz: Hi, I'm Christine Benz for Morningstar.com. I recently attended the Morningstar Ibbotson Conference, where [Morningstar senior investment consultant] Sonya Morris talked about how to select active fund managers. I had the chance to sit down with Sonya to talk about how to know when to sell a fund.
Sonya, thank you so much for being here.
Sonya Morris: Thank you, Christine for having me.
Benz: One of your key jobs in your role at Morningstar is to select and monitor fund managers, and you do this for a living. So I’d like to get your guidance, Sonya, for our Morningstar.com users what should they think of a sell triggers when deciding whether to sell a fund. We recently had a discussion with our users in our Discuss forums, and it seemed like there is a lot of confusion about this issue. Readers said that they had sold funds that they later regretted selling or maybe they had held on to funds too long. So I'm wondering if you can kind of talk about how you think about selling, when do you make that decision whether to sell.
Morris: Sure. Well, I think really the key is to have appropriate expectations at the outset. So whenever we select a manager for a portfolio or for a Morningstar Select list, we write down why we chose it, the role we expect it to play in the portfolio, and also what our expectations are around performance. If any of those expectations are not met for one reason or another, that's a trigger to us to do a closer look at the fund and possibly consider replacing it.
Benz: So you mentioned performance and setting expectations for performance. How do you do that? You don't know what the market will do. You don't know how a fund will perform in specific environments. How do you go about setting those performance expectations?
Morris: Well, before we select a fund, we look at performance from as many possible angles as we can. So we’ll look at performance during uptrends, during downtrends. We’ll look over rolling periods. We'll look at risk metrics, like upside capture ratio, downside capture ratio, and max drawdown--anything we can to give us information to help us set some sort of framework about what to expect going forward. So our goal is to have expectations about how a fund might perform in a variety of market conditions.
Benz: If you bought a fund specifically for its defensive characteristics, thinking it would be a good downside performer, would it be a red flag if you saw that it went on to lose a lot more than its peers in the down market?
Morris: Exactly. If we owned a fund like that, and it didn’t outperform in 2008, that would be an extreme disappointment to us, and we’d want to understand at the very least why that happened.
Benz: You wouldn't necessarily kick it out, but it's a reason to do some further digging.
Benz: Then there are other fund-based things that you look for, that you consider red flags, and I’d like to cycle through these. One thing is a manager change. Is that definitely cause to give a fund the boot, or what do you do at the point when you hear a marquee name manager is leaving?
Morris: Here again it's important to do your homework upfront, not only to know who the manager is but also maybe who some of the key players are beneath him, who his analysts are and maybe who his comanager is. Hopefully, you are in a situation so you know who the replacement is and you understand that they’ve been with the firm for a number of times. That's the best-case scenario.
If not, you need to understand who the successor is, how long he’s been associated with the manager, and if he’s going to be following a similar strategy to the manager [who was the reason we initially bought the fund].
Benz: So our Morningstar.com users aren’t necessarily in a position to do that kind of due diligence, but our analysts usually touch on the depth of a team when they cover a fund in their Analyst Reports?
Morris: Correct. They usually do an excellent job of covering who the supporting players are for the managers. So that's something, and they generally do a good job of revisiting an analysis when there is a fund manager change.
Benz: Another factor that you say you look at is this concept of stewardship, and that is sort of the whole fund company, how they treat their shareholders. What might be some stewardship red flags that would cause you to consider selling something?
Morris: We’re generally more invested at the outset with good stewards. So we want managers who write very forthright and detailed commentaries that give all of their shareholders good information about what they are doing and why they are doing it. So those are things that we like to see.
We’d like to see expense ratios decline as assets grow; it’s a sign that they are sharing economies of scale with shareholders. We also like to see fund managers eat their own cooking and invest alongside [shareholders]. So those are things that we look at from the outset.
Disappointments to us might be things that a fund company might do rolling out sort of niche funds that seem to be motivated more by the sales team than by investment competence. That would be something that would be a red flag to us that will start to tarnish our opinion of a fund company as a steward.
Benz: How about strategy changes? Is that something that would cause you to look askance on a fund and possibly consider giving it the heave-ho?
Morris: Yeah, that goes back to those guideposts that we originally wrote. We picked a fund for a reason, to fill particular role in a portfolio. So if we get a strategy shift, that can really throw all of our portfolio off-kilter. So that could be a very good reason to revisit a fund and look for a fund that is more appropriate for that slot in a portfolio.
Benz: How do you balance that though because it seems like fund managers naturally might make small adjustments to keep their fund in step with the times? How do you balance those sorts of tweaks with tweaks that are truly worrying and show that the fund is diverging in a fundamental way from its original strategy?
Morris: We are continually monitoring the portfolios as they come into us. We want to make sure that the portfolios are consistent with our understanding of the broad strategy. But, yes, I think that's the reason you hire a manager, I think to have the expertise and the nimbleness to respond to market changes as they occur, market dynamics.
As long as everything is consistent by broad strokes of [the manager's] description of a strategy and our understanding of it, we think that's not necessarily a strategy shift in our mind.
Benz: So the last point I wanted to touch on is this question of capacity, asset size, funds getting large quickly. Let’s talk about how investors should think about that, looking at a fund growing, growing, growing that maybe was small at one point. When is size and asset growth a red flag for you?
Morris: It's particularly a red flag in areas where illiquidity is a problem. So in particular, the small-cap arena is one area; high-yield is another. High-yield municipal bonds is another area where we’re paying attention to asset size.
We’re going to have a frank conversation with the manager about that. We want to make sure that he is thinking about it and he is being proactive about it, and have some strategies for handling that should that issue arise. But if we suspect that it's happening, we’re going to be looking at things like the number of fund holdings, for example. If we start seeing the number of stocks in a portfolio increase as assets increase, that can be a sign of asset bloat. It's going to water-down the manager’s best ideas.
We can see a small-cap fund sort of migrate up the cap ladders and become a mid-cap fund. That's in paramount to a strategy shift, which is what we just talked about. And also we can see turnover decline if the manager is having issues, trading in the smaller stocks in his portfolio. So those are all telltale signs that we might need to be concerned about capacity.
Benz: So in a case like that, do you think about taking that fund out and replacing it with a more nimble option, maybe something newer?
Morris: Yes, we will. Obviously, it needs to be old enough that we can have some conviction about the skillsets of the managers running the fund, but yes, if we don't have any faith that this fund can fulfill its role in the portfolio and then it's going to be hampered in delivering our performance over the long haul, we’re going to take a hard look at replacing it with a better idea.
Benz: Sonya, thank you so much. It's obviously more art than science.
Benz: But we appreciate you sharing your insights into this important topic.
Morris: Thank you, Christine.