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Russel Kinnel: 'Fear and Greed Are the Enemy of Good Investing'

Morningstar’s director of manager research on 'Flowmageddon,' seismic shifts in the fund industry, and why fund-company mergers usually fizzle.

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Our guest today is Russ Kinnel‏. Russ is director of manager research for Morningstar Research Services and the longtime editor of the Morningstar FundInvestor newsletter. As part of his duties, Russ chairs the North America ratings committee that oversees and approves the Morningstar Analyst Ratings that Morningstar's manager research analysts assign to the funds they cover. A mainstay of our research efforts for years, Russ has authored a number of well-known and widely cited studies, including the annual “Mind the Gap” study of investor returns, and is frequently quoted in the financial media. Russ is a graduate of the University of Wisconsin-Madison, where he received his bachelor's degree in economics.

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Related Articles

Environmental, Social, and Governance Investing,” Morningstar.com.

What Helen Young Hayes’ Departure Means to Janus,” by Russ Kinnel, April 21, 2003.

Lessons From the Bill Gross Saga,” by John Rekenthaler, Morningstar.com, Oct. 1, 2014.

Flows + Bloat = Headaches for Funds,” by Russ Kinnel, Morningstar.com, March 27, 2017.

Fink: BlackRock Continues to Evolve,” by Daniel Culloton, Morningstar.com, April 28, 2017.

Enhancement to Sustainability Rating Emphasizes Material ESG Risk,” by Jon Hale, Morningstar.com, Nov. 8, 2019.

Where the Medalists Are,” by Christine Benz and Russ Kinnel, Morningstar.com, Sept. 15, 2020.

The Best Fund Companies and Their Ratings,” by Russ Kinnel, Morningstar.com, Jan. 28, 2020.

Flowmageddon: Is it Time Yet?” by Russel Kinnel, Morningstar.com, July 24, 2020.

Mind the Gap: How Do Investor Returns Stack Up Against Total Returns?” by Amy C. Arnott, Morningstar.com, Aug. 18, 2020.

Can Bond Funds Grow Large More Gracefully Than Stock Funds?” by Christine Benz and Russ Kinnel, Sept. 22, 2020.

Farewell, Mutual Funds,” by John Rekenthaler, Morningstar.com, Jan. 21, 2021.

A Quick Survey of Investment Vehicles,” by Russ Kinnel, Morningstar.com, Jan. 20, 2021.

Transcript

Jeff Ptak: Hi, and welcome to The Long View. I'm Jeff Ptak, chief ratings officer for Morningstar Research Services.

Christine Benz: And I'm Christine Benz, director of personal finance for Morningstar.

Ptak: Our guest today is Russ Kinnel‏. Russ is director of manager research for Morningstar Research Services and the longtime editor of the Morningstar FundInvestor newsletter. As part of his duties, Russ chairs the North America ratings committee that oversees and approves the analyst ratings that Morningstar's manager research analysts assign to the funds they cover. A mainstay of our research efforts for years, Russ has authored a number of well-known and widely cited studies, including the annual “Mind the Gap” study of investor returns and is frequently quoted in the financial media. Russ is a graduate of the University of Wisconsin in Madison, from which he received his bachelor's degree in economics. Russ, welcome to The Long View.

Russ Kinnel: Thanks for having me on. I'm excited.

Ptak: We're excited to have you on as well. A lot of our listeners, I think, are probably familiar with you, but not all of them. So for the benefit of those who are getting to know you for the first time, can you talk about what you do at Morningstar, the role you play?

Kinnel: I am a 26-year veteran of Morningstar, and my current role is I head up the U.S. ratings committees, which vet all of our analyst ratings. I also edit Morningstar FundInvestor, which is a monthly newsletter for individual investors. And I write an occasional study and I write columns for the Morningstar.com website under the Fund Spy tab.

Benz: Russ, 26 years, it's a long time, you've seen a lot of change in the fund industry. I wanted to get your response to a piece from our colleague, John Rekenthaler last week, where he talked about ETFs, essentially eating mutual funds’ lunch, and his assertion is that were it not for investors being sort of inert and maybe lazy, that mutual funds might go away altogether, that ETFs would completely take their place. What's your reaction to that? Do you agree with that?

Kinnel: Not entirely. I think he's right. I mean, it's clear that ETFs are eating mutual funds’ lunch. And for good reasons, they do have some real advantages. I don't see mutual funds going away, though, as I've pointed out in the past, when I've written these Flowmageddon pieces. The open-end mutual fund industry is right near its all-time peak of AUM, so it's got a long way to go to zero from here. Now, that's been burnished in part by the market appreciating so much that typically the markets appreciating by more than outflows are hitting open-end funds. And obviously, that's not necessarily going to continue forever; we got a bit of a taste of that with the little severe bear markets in 2020. But obviously longer term that suggests that the open-end industry is in for some real challenges. So, I think, unless they can come up with something to really tilt the tables the other way, I do think the fund industry is looking at contracting and gradually losing share to the ETF world. Of course, ETFs largely come from fund companies, too, so many of them, they don't really care that much. But I do think long term that's where it's headed. I do think funds add a lot of value and do have a lot of appeal and work very well, particularly for things like steady investments, etc. I do think there's some good reasons for funds to still be around there. But I think John is right about the general trend.

Ptak: Russ, you play such a central role in conducting research of mutual funds at Morningstar, through the years and in the industry, for that matter. Can you reflect on some of the differences, in researching, in choosing funds, say now versus in the earlier part of your career? What would be most striking, to an observer, the differences between now and then?

Kinnel: I think just sophistication all around. When I started, there weren't a lot of data points beyond performance and fees, but also in terms of strategies. A lot of the strategies were pretty simple. Buy stocks that go up, hope to outperform the market--very simple strategies. A lot of funds might have been one manager and a handful of analysts. So much more sophistication in terms of strategies. Think about Pimco, which when I started barely existed as a mutual fund company, but is a giant operation with tremendous derivatives, trading desks, very sophisticated strategies, currency plays, all sorts of trading desks. There's just a much greater level of sophistication among strategies. And, therefore, the analysts have had to evolve with that. We started off doing a one-page report that was mostly descriptive. Today, it's seven pages, and it's much more analytical. We're using Direct, which for those who don't know about Direct, is a massive institutional-level platform with massive amounts of data. We can run attribution, so we can see what's driving a fund's performance, how did it do well, what's it bad at. Fund companies will often have their own version of attribution we can look at. We ask for mountains of data from fund companies. When we rate a fund, there may be a 20-page analyst note, plus a 30-page attribution document. There may be a bunch of other documents from the fund company.

It's a much more sophisticated process, much more complexity. And in a way, I think that illustrates our value even more than before, because it is hard for even sophisticated financial planners to understand all of what's going on at a Pimco or a BlackRock factor fund or something like that. So, it's really a lot more data, a lot more sophistication. But at the end of the day, of course, investors still are just trying to reach their goals. And so, in some ways that keeps us grounded.

Benz: What do you view is the keys to success in picking a fund that will outperform and deliver a good investor outcome? What are the key factors that you would highlight? And how do you think those have changed since you started your career as an analyst 26 years ago?

Kinnel: I think it's about focusing on the fundamentals. We know that fear and greed are the enemy of good investing. And so another way of saying fear and greed is performance. If you focus on performance, particularly short-term performance, you're largely going to be led astray. So instead of focusing on fundamentals, and by that, I mean, understanding the fund company, the fund strategy, the managers, and how all those things go together. And I think the key lens for that is competitive advantage. Do the way that these fundamentals come together amount to a competitive advantage that can last for you over the long time? Of course fees are the first part of that story, because fees are the best predictors of performance. And the reason is very simple. It's just math that the more you charge, the harder it is to overcome that hurdle. And in bear markets and bull markets, fees are generally the same.

It's really about how all those things come together. And I guess I would say, the way that's changed is, I think we've developed a greater appreciation for what are the real fundamentals. We've been able to test these things--I mentioned the attribution and other tools we can use that we didn't have before. We do a lot more fund company visits--at least we did prior to COVID--than we did back when when I started. We're able to spend a lot more time understanding, not just the managers, but the analysts and traders and the culture of the firm. And you really need all of that to select good funds. And then on top of that, you need patience to get to that end goal, because funds are going to have their ups and downs. Even index funds, particularly active funds, are going to have moments where they look like idiots and moments when they look like geniuses. And you need to recognize that a lot of that is noise if you want to get to your goals.

Ptak: One of the things that I'm sure the past two decades plus has reinforced for you is that picking active funds is difficult. And that's a challenge that everyday investors face. What would be your guidance to an investor that is trying to self-assess and ask themselves whether they're cut out to choose active funds versus just choosing an index fund or an ETF? Do you think it's fair to say that the vast majority of individual investors, let's say, should be indexing instead of trying to choose an active fund? Or do you think that sells them a bit short?

Kinnel: I would say a lot of people should have a good part of their portfolio in passive strategies. I'll put it that way. Because passive works nicely in a couple of ways. One, they're lower maintenance. Not everyone has the time to do the research. So, we can do a lot of that work. But you still need to do more work if you're picking an active fund because managers can change, strategies can change. Whereas an index fund, the well-designed ones anyway, just keep on chugging and are much lower maintenance. I think it does take more work, and it probably takes a bit of dispassionate skills that you have to be willing to not get too involved, and I think, also have a decent strategy. In other words, have a plan, know what that plan is, know each fund's role in that plan. So that when problems arise, say you're looking at your funds in March 2020, you don't panic and sell every value fund, you don't panic and sell every high-yield fund. It's also about your disposition. I think a lot of investors can use active funds. If you don't have a lot of time, it makes sense to lean more heavily on passive for sure.

Benz: What are the areas where you would say “by all means go passive”? And then what are the other areas where you would be more inclined to say, “I think you could have a reasonable outcome with an active fund”? So just in terms of categories or asset classes?

Kinnel: I think, obviously, the first place that passive makes the most sense is large-cap equities, both U.S. and foreign. The record of passive funds there is outstanding. I think it makes a lot of sense there. Myself, I own some active funds in that space. But I think, by and large, passive ought to be at the core. Another area where passive works quite well is high-quality bonds. I think it probably makes more sense to have passive there. But then you might add, say intermediate core plus or some other funds around there, because the further you get out from that core of bonds, the more active makes sense. I think emerging-markets equities make a lot of sense for active; we've seen passive hasn't worked quite as well there. There are some other strategies where for one reason or another passive just doesn't work well. Sometimes it's just hard to build a good benchmark. Bank loan, high yield--those are areas where passive really hasn't solved all the challenges there. And so, I do think that around the edges, there are some places that are really ripe for active management.

Ptak: I wanted to ask you about a term that our colleague Don Phillips has used from time to time. I think he refers to it as the “tyranny of the articulate,” and he's talking about portfolio managers, who could be very persuasive by sheer virtue of the fact that they are so articulate in presenting their views. So cogent in the way they present their logic behind how it is they invest. So my question for you is, how do you ensure that for yourself and for the analysts who you work with, that they aren't susceptible to that type of persuasion? They take a real hard look at what a manager is doing, irrespective of how influential they might be in presenting their thesis?

Kinnel: I think that newer analysts are particularly susceptible, because the first few times you see someone go through a flipbook and talk about their strategy, they sound so smart, especially if their last three years’ performance looks really good. You think, “Wow, they really get it. They knew about Tesla, they just nailed it.” And so I think you're right, that articulate manager can deceive a bit, partly because we know there are some really smart managers who aren't so articulate. But also, some fund companies put an emphasis on salesmanship and that leads them to put those articulate managers in charge, but that doesn't necessarily mean they're actually that good at investing. Among the ways to ground them, is the analysts on those funds is, look at the data, really assess the fund, and a lot of different tests before you talk to the manager. But also verify that they're actually doing what they're saying.

The manager might sound really articulate, but then you dig in and you say, “Well you said you'd care about valuations, but you bought Zoom after it had tripled in a year.” Or you say, “You're really in depth about your company research, but three of your bonds defaulted.” I think you need a fair amount of scepticism; you need to let the data tell you their stories. And I think it's also about having that context. When you just talk to a few managers, they might all sound really smart. But you need to think about what are some of the other managers doing? Are they even better? And I think finally, just recognize that all systems and all humans are flawed. And nothing's quite as good as the manager is going to present it.

Benz: Russ, you mentioned that the team does a fair amount of these company visits, where you're visiting on-site with fund companies, that you did a lot of that pre-COVID and hope you'll return to that post-COVID. Can you talk about what goes on with with those company visits, what you glean from them that you feel like you couldn't get from a phone call?

Kinnel: I would say, a typical fund company visit, we might have four or five analysts out there--we might go to LA, we might visit three or four LA bond shops, or three or four LA equity shops at a time. Bridget Hughes, who leads our parent coverage is often there. We typically spend, say, a day at a fund company, it depends on their size; occasionally we'll spend two days. If they're smaller, maybe a half day. But we're looking for a lot of things… I talked about competitive advantage. So understanding, is that still there? Are they still as good as we think they are? But we also want to go beyond the manager to understand that culture. Say we talk to analysts--what led them to choose that firm; what led the firm to hire them in the first place? We want to understand how everyone's working together. When you talk to 30 people from a fund company, you can really hear, are they really all on the same hymn book? If there was a fund company merger, we might talk to the first five people, and it sounds like everything's great. But then the next two people might say, “Yeah, I'm really not happy with this.” Or “I'm really not working with those people. I know they say there is synergy, but there's not.” So really talking to a bunch of people helps.

And I think finally, when you talk to them at their location, they tend to be more relaxed, they tend to be a little more free-flowing. When you talk to them just about one fund, it's a little more focused conversation. You don't necessarily pick all those things up. We'll talk to traders, we'll talk to compliance people, we'll talk to salespeople. So really we're trying to really understand that culture. And I think it really can take you in a different direction that you just don't see with an individual fund conversation. Sometimes we'll go and they'll bring all their analysts. I've visited Matthews a couple times. And they put all their analysts in a room and it's certainly an interesting way to interact and to just really appreciate what's the talent level, what's the experience level, and what motivates people.

Ptak: You alluded to something that can test a firm's culture, which is mergers. And given the state of the industry, which you described earlier, it sure seems like we're going to see a lot of consolidation going forward. And so, for those who are choosing managers, they'll be tested because they're going to have to reassess cultures that maybe they were formerly confident in that are now being tested by mergers. What would you suggest they ought to focus on as they’re making those assessments of whether a firm's culture can withstand a merger and basically assimilating a new culture, ensuring that the whole exceeds the some of its parts, so to speak?

Kinnel: I think you have to recognize for the starter that mergers are really difficult. As Larry Fink said, “mergers suck.” And Larry Fink actually pulled off two pretty successful mergers and I think he may have the right idea that you only want to really try a merger if it's really going to move the needle for your company. What you have to recognize, I think, is that you have a combination of cultures and sometimes those cultures clash. And initially, you usually hear a lot of spin. But in truth, we often see, managers or analysts start to trickle out. Or sometimes things don't work or it might be a year or two, after the merger, that the fund company decides, we're going to get rid of 15 funds. So, I think one of the challenges with a merger is simply that it's a long-running story and you have to keep coming back. A manager change in an individual fund can be a fairly simple story, they've got a new strategy, you check a couple of times to see if they're really living up to that.

But a fund company merger, there's just a lot more complexity. Sometimes, they'll ask a bunch of employees to move from one place to another, and inevitably a bunch decide not to make that move. Usually, when they ask them to make that move, it's because they don't really care that much if they move or not. Other times, if the acquired fund company is really shooting the lights out, the buyer will be very hands off. There is just a really wide range of approaches. Going in, you want to understand, what's the motivation for this merger? Are they saving costs? Are they trying to add an asset-class skill that they don't have? Because that will help you to understand is it likely there are going to be a lot of mergers, but you just have to recognize, there are a lot of problems with mergers. And it's a very hard thing to pull off well. So bring a lot of scepticism to any fund company merger, I guess.

Benz: You referenced at the beginning of the conversation, what you call Flowmageddon, these tremendous outflows that we've seen from funds. Can you talk about things that the fund industry could do at this point to try to stem that tide? Are there changes that they could make to how they operate to the products that they offer? What do you think could could turn this around for them?

Kinnel: Well, I think one thing they could do is, is get more competitive on fees. We've seen fees come down in the open-end world. But some places really not much at all. Some simply say, well those ETFs are going to be cheap, and we're not going to try and compete with them. I understand you can't necessarily match their fees, but you could provide a better value proposition by lowering your fees. And I think sometimes when they don't lower fees at all, especially the higher-cost firms, it kind of tells me, “OK, you're just using this as a cash cow, aren't you? You're going to get what you're going to get for as long as you can get it. You're not really trying to compete; you're kind of conceding. Especially let's say, you run a core-bond fund, high-quality bond fund, at a time when yields have come down substantially. But you're going to keep on charging 80 or 90 basis points. Well, you're just not really trying to compete, are you?”

So, I think you can do a better job on fees. And I think also just really continue to develop competitive advantages and move on from those areas where you really don't have them. There are still a lot of funds out there that are just OK. And that's why there's money going out. And then I think finally, I would say the funds are not always so good at telling their story. We see money going out of really well-run funds and that's a little disappointing. And I think the debate has really been won by ETF providers. And I think open-end providers need to do a little better job of just explaining what their value add is. There are more active ETFs out there and certainly open-end managers who think that can work and can join them. But most of the good active strategies out there are open-end only and I think they could do a little better job of explaining their real advantage and getting attention to those strategies.

Ptak: Since we're talking flows, maybe it makes sense to talk about one of the most influential studies that you've run, which is called “Mind the Gap.” And “Mind the Gap” for listeners who aren't familiar, essentially what we're looking at is the dollar-weighted return of funds. So, when a fund typically reports its return, it's assuming a lump sum investment. It's bought, it's held to the end, and that's the return you earn. Whereas dollar-weighted is something that is similar to an internal rate of return, which reflects the timing and magnitude of cash flows. And what I think you observed over a number of years is that there could be a very wide gap between the returns that investors actually realize and the returns of the funds that they invested in. My question for you is, it seems we've made some progress in narrowing that gap. But do you see risks that investor behavior will become, the bugaboo for a lot of investors that are out there where they're mistiming their investments and chasing after the latest hot fad that perhaps is out there?

Kinnel: Yeah, I think you're right. Things have been really improving, particularly when we looked back at, say, the trailing 10-year period for 2018, 2019, we saw that gap really shrink to 30 to 40 basis points on an asset-weighted basis, which is really a pretty good outcome to my mind. That means timing, essentially, it's the cost of timing is that gap. And so it tells you that timing did cost some, but it wasn't a disaster. You worry about when something that costs someone 300 basis points or 1,000 basis points, that's when you're really doing damage. But, of course, those periods--10-years trailing 2018, 10-years trailing 2019--were wonderful times to invest. Bonds did better, stocks did better. So, you really had this nice circle of money going in and good performance. But, of course, 2020 slammed on the brakes. And we had a bear market. It wasn't that long lasting.

And oddly enough, just before the bear market, and just after it, we had tremendous greed. We had the Teslas and other companies and we had some funds record triple-digit returns. So, we had a massive dose of fear and greed last year. So I'm really interested to see what the results look like, for end of 2020 and going forward, because we just had a massive stress test and the prior bear market, the '08-'09 bear market, it took a long time for greed to come back, it was much more a sober time where it was hard to convince people to come back. But because we had this dramatic difference in markets, value particularly got crushed in the bear market. Growth just did really well, because a lot of growth companies were eating values' lunch, and a lot of growth companies had solutions that would help people work from home, etc. So obviously, Zoom or Amazon or Apple, those companies have really thrived. I think it's certainly possible that gap has widened and may continue to widen. And, of course, underlying all this, we can't measure it on a fund basis, but we know there are endless stories about the speculation of Robinhood, GameStop going crazy and other ones. So, we have a bear market and a speculative frenzy somehow all at the same time.

Benz: Well, that's what I wanted to ask about Russ. And that's something we've been obviously discussing a lot internally recently is just what are the parallels with that late ‘90s, very beginning of ‘00s period with today? Can you talk about that? Can you talk about whether investors are potentially courting big dangers as they were back then?

Kinnel: I think there are some some clear parallels. A lot of people have taken up day trading. If you go back it was, I think it was Discover Brokerage that had the tow truck driver who bought his own private island through day trading. So, yeah, there's some of that speculative frenzy is back. Internet and tech companies are blowing the doors off once again, value has been left in the dust once again. So, I think there are some parallels. I think there are a couple positive things. One thing is that a lot of those dotcom boom stocks in '99-2000 had no earnings and quickly went bust. Whereas most of the companies that are getting speculative frenzy are real companies today and are going to survive. I feel confident that Apple and Facebook and Zoom will be around in a few years. I think that's a positive. Tesla will probably be around. I think those are positives out there.

However, of course, when we had that 2000 to '02 correction, a lot of it was just simply about multiples, that multiples had gotten crazy. And certainly we're vulnerable to that today, as well as a lot of these growth stocks, particularly a FANG-like companies have done, they do have some crazy multiples. And at some point, sobriety might come back. Another element in both cases is the interest rates were low. And I think low interest rates have made Robinhood trading at a lot of the speculative frenzy very, very easy and have really been a fuel to that fire. I have no idea where interest rates are headed. But obviously, one possibility is they could go up a lot. And that would make me worry about growth stocks.

I think there's certainly a lot of similarities. I think one thing that did change also is value stocks really did lose some ground. You think about big-box retailers or REITs. And they'll probably come back but in a diminished capacity. I think the good news is a lot of value companies are still making profits, will probably still be around here. So you might say, maybe you feel comfortable owning value stocks today, because they may well be cheap, even as growth has gotten really speculative. But we're definitely in uncharted territory, even though there are some parallels with '99-2000.

Ptak: Another thing that's pretty different about that era, compared to the current one, is there are far fewer star managers, so to speak, then there used to be. I'm curious, as somebody who's watched the fund industry so closely through the years, what does that say about the fund industry? And what does it say about investors?

Kinnel: You're right. It's no longer star managers. The Janus managers were huge in '99--Helen Young Hayes, Scott Schoelzel. It's not so much the managers; it's much more like Elon Musk, it's the people running the companies. Star managers have gone away, a lot more funds are team managed. And I'm not sure that's a bad thing. I think maybe people put too much faith in star managers back then, maybe the financial press overhyped the appeal of star managers. I'm not sure that's such a bad thing. In a way, Pimco Total Return with Bill Gross' exit was one of the stranger star manager stories in that Bill Gross was a huge star on CNBC all the time. Running the massive Pimco Total Return, the biggest bond fund at the time. But he was surrounded by a great team at Pimco, of managers, analysts, traders. So on the one hand, it was kind of a star situation.

On the other hand, it was not. And then bizarrely, Bill Gross left with the plans to start up at Janus the very next week. There's debate about how much he was fired or quit. But in any case, a really amazing thing, because of course, typically managers are on contracts that have garden leave, a lot less-famous managers have to wait six or 12 months before they can go to another firm. But, of course, because Bill Gross was largely in charge of Pimco, no one was going to make him sign that deal. And so in reaction, we had the greatest outflows of all time as people fled, and yet, I think after Bill Gross left, Pimco was in better shape. You had three very good managers take over, you had some people come back to Pimco who had been driven out by Bill Gross, apparently. And so in a way it illustrated the strength of having a trio of managers and even though a lot of money went out, the fund just kept on chugging along. And it's a very good fund today.

I suppose if you wanted to mark the death of the star manager, maybe that would be the moment, because in a way, it was a little deceptive that Bill Gross--on the one hand he was a star, but he was really part of a huge team that was at Pimco and much credit to Gross for building that team. He had the foresight and the skill to build that team with the help of others. But it also meant his departure was actually probably a good thing by that time.

Benz: I wanted to ask about hubris, Russ, and how you and the team think about that…

Kinnel: Thetransition.

Benz: Well, I know, I was weighing in my mind how to bring it up. But this idea of overconfidence in managers, and how you and the team try to be on guard for that, it seems like that's potentially a big risk factor. What are the signs? What are things that you've observed in interacting with managers in the past that indicate, well, maybe they are a little too full of themselves and a little bit too confident in their abilities? And maybe this is kind of poisoning the organisation because no one is really able to speak up to that individual. Can you talk about that?

Kinnel: I think the good part is that fund companies have become more sophisticated and that industry has matured, and so therefore, the manager with free rein to do whatever they want--there are much fewer of them in that mode. I think there are lot more checks and balances, there's a lot more risk management, risk controls. Just about any fund company of any size would have risk monitoring and regular risk reports that go to, not just that fund manager, but to that fund manager's boss, to the board that oversees them. And, of course, we're doing our own monitoring, and we can see, “Oh this manager has diverged in their strategy.” So I think there are more checks on that than in the past, but for sure fund managers are still very much alphas, they still have huge egos. And I think that's still an issue.

One of the ways that hubris comes across to me is fund managers who are very casual about their AUM. Because they've been so successful up to this point, money just keeps coming in. And inflows are of course easier to manage than outflows unless you're in really liquidity-constrained area. So, it all seems great. The managers are walking on water, and they kind of have a, “I'll know it when I see it,” attitude about AUM. And then, of course, at some point, maybe they do get too big and that hurts performance, or the performance goes bad for reasons not necessarily related to AUM and then AUM flies out the door. And all of a sudden that creates a lot of problems. And I've heard managers who will say great things about their shareholders when the money's coming in, and then say how they're a bunch of idiots, as money flows on the way out.

I think that's one way. I think you see managers will try some new things that maybe are a little outside their skill set; maybe they'll start to take on bigger risks. Or maybe they'll be less amenable to input from the analysts and others on their staff. So, for sure I think ego is always an issue out there. And the catch is that a lot of the successful managers have huge egos and sometimes just keep on being very successful. You can't simply say, “That manager has a big ego, we're not going to trust them anymore.” You have to really see, is that ego becoming a problem?

Ptak: Capacity management and assessing that is, as you describe it, it's a really, really tough thing to do. If you had to advise someone on how they should go about that, what should they look for? It seems that maybe one indicator of that is whether this is a firm that has a track record of closing strategies in the past, but that won’t be true of every firm. So are there certain things about a strategy that they should be looking at and monitoring in order to determine whether it's a strategy that's beginning to bump up against its capacity limitations?

Kinnel: I think you're right. Obviously, a firm with a good track record for closing is ideal. Some funds themselves have reopened and closed numerous times. So that tells you something. One thing I really like is when the fund managers will tell you well in advance what their capacity is, and when you ask them how they arrived at that, they've got a very sound explanation for why they have that capacity estimate. I love to hear that because it signals, “OK, they've been thoughtful about it and they have a plan.” For instance, Champlain, their managers when they left their previous firm, were very explicit about not wanting to run as much as they had in the past. And we've heard that at other places.

I think that's ideal. I think you obviously want to understand how AUM-sensitive is the strategy. Does it have really high turnover? Is it in less-liquid holdings? So, for instance, does it own high yield or bank loans or small caps? And so I think you want to understand all of those factors, and also recognize that with AUM, there's a couple of issues: It's the rate of inflows as well as the total that they have to manage. You want to keep an eye on both of those factors. And, obviously, as analysts, we're monitoring the impact. So, we look at things like is the fund moving up in cap? Is it adding more names? Is it adding futures or some other tool to manage liquidity? In the case of bank loan funds, we will look and see--sometimes they have to tap lines of credit because bank loans are particularly illiquid investments, or relatively illiquid, I should say. It takes a little longer to trade them than a normal bond.

Benz: I wanted to ask about something you referenced before, Russ. You mentioned that investors seem to be giving up on some good-quality funds in some cases. Let's talk about that--good funds that investors are dumping. Can you share some examples of funds that you think investors are fleeing from where they really ought to be exercising more patience?

Kinnel: I think just large-cap active. You can see that a lot of large-cap active--so I'd say large-cap active medalists is probably the biggest category of funds that are undeservedly being sold. I'll often see money going out of some great names like Fidelity Growth Company or Fidelity Contra Fund. Some of the American funds, you see money going out of. As an investor, I don't necessarily mind that because those are really big funds. If the money is going out gradually, that actually seems like a positive; but on an individual basis, that may not be the best decision. And, of course, a lot of value funds are under pressure these days. I think there's some very good value funds, and dividend growth strategies like Vanguard Dividend Growth, Vanguard Equity Income have occasionally had some AUM pressure.

I think there really are a lot of names out there. And I think, beyond the big fund companies, you see some of these smaller firms. If they just hit even just a three-year stretch of average performance, they'll often get sold unfairly. I think the positive is that if you look, in say, small-cap fund land, there are almost no closed small-cap funds. So, to me, that's an opportunity. If you screen for, say medalist small-cap funds, nearly all of them are still open, whereas a lot of times in the past that wasn't the case. The good news is, you can have your pick of great small-cap managers.

Ptak: As you reflect on innovation in the fund industry, I think that probably we have a somewhat tortured relationship with innovation given the fact that we've seen so many flimsy ideas come and go and some investors have gotten burned in the process. But if you had to give somebody advice on how it is they should assess a new idea and whether it's the sort of thing that's likely to confer a good outcome in the future versus just another gimmick that's come along, how would you suggest they go about that?

Kinnel: Good question. You want to know has this idea evolved naturally from a good research standpoint? Or does it sound more like marketing? Does it have some good underlying fundamentals? Does it really solve a problem that needed to be solved? On the other hand, look out for that free lunch. I think particularly in the alt space, so many alternative strategies have been positioned by marketing people as this free lunch, where somehow you get all of the market's upside and none of its downside, or something like that. So always be wary of those free lunches. Another area, of course, where people overpromise and underdeliver is income, because there's tremendous appetite for income. I would say any innovations in income, be very careful, because a lot of it is a way to pump up income at the expense of a lot of risk.

Benz: One thing about our manager research team is that you've got a lot of people who are really good at debating issues. And so I'd like to hear about some of the debates or maybe one of the debates that's raging within the team currently that that people are actively batting back and forth over email or in meetings.

Kinnel: I think 2020 really created a lot of challenges for us, because the performance was so extreme, because taking one kind of risk, that is price risk going for the growth was rewarded tremendously. And on the other hand, sticking with deep value was punished excessively. I think it's really hard for us to decide how much weight do we give to 2020. How much do we ping value manager or a high-yield manager for having energy companies? How much credit do we give a manager for holding on to Tesla today when valuations are extreme? And I think part of what we try to do is understand, well, what was the process? How did they arrive at that? Is that consistent with their process? Did they make some mistakes? What did they tell us in the past they were going to do? And our answers come up differently. We've downgraded some deep-value funds, we've maintained ratings on other deep-value funds, some growth funds have been upgraded, others have not. Some growth funds have been downgraded because of the extreme risks. Baron Partners one extreme case, we downgraded because Tesla got up to almost half of AUM. But, of course, that meant performance was awesome. It's a real challenge when you have a year this extreme, and a year that really is almost unprecedented. We talked about '99, but it still feels different to me. I think really understanding performance and understanding the fundamentals is harder than ever.

Ptak: For our last question, we'll ask you to shift your gaze forward and talk a little bit about the future of fund research and fund selection. We haven't talked too much about ESG or more customized approaches to investing. You hear people talk about mass personalization and the like. So how do you think that will affect the way you and your colleagues go about conducting fund research? And do you think that investors will define success differently in the future than perhaps they have in the past?

Kinnel: I think you are right, customization, because of the technology, there's tremendous potential customization. But I think ESG is something I'm particularly interested in. Obviously Morningstar, we're doing a lot more with assessing ESG funds on both their traditional fundamental merits as well as their ESG merits. There's a lot of interest in the U.S. and Europe in ESG. And we're seeing fund companies really improve their efforts on ESG. A lot of resources are being moved into ESG. And I think it's going to be fascinating to watch, because obviously ESG can be defined very differently. What kind of screens, how active are they? And I think we're going to see a lot of evolution in that place, both from the fund companies as well as advisors and pension funds in defining their ESG goals or deciding not to pursue ESG.

It's going to be fascinating to see how all these strategies evolve. And then what are the performance metrics? It's largely put out there as a risk-assessment tool. So how do they do on risk? How do they do on performance? How do they alter the equation for similar funds versus funds that don't pay attention to ESG? It's all kind of fuzzy. And I think we're getting a lot more data, so I think it's going to be fascinating to watch. If you think about how ESG is defined today, we really have only started to run funds in that way, the last, I don't know, three to five years, and only a handful of funds. So that means we have very little performance data on ESG as it’s defined today. It's going to be really fascinating to see what results we get and how that space evolves. I'm particularly interested in how that's going to work. And I think how the big fund companies decide to set themselves up on that ESG debate is going to be interesting, too.

Ptak: Well, speaking of interesting, Russ, this has been a really interesting conversation. Thanks so much for sharing your time and perspectives with us. We really enjoyed having you on. Thanks again.

Kinnel: You're welcome. It's been fun.

Benz: Thanks so much, Russ.

Ptak: Thanks for joining us on The Long View. If you liked what you heard, please subscribe to and rate The Long View from Morningstar on iTunes, Google Play, Spotify, or wherever you get your podcasts.

You can follow us on Twitter @Syouth1, which is, S-Y-O-U-T-H and the number 1.

Benz: And at @Christine_Benz.

Ptak: George Castady is our engineer for the podcast and Kari Greczek produces the show notes each week.

Finally, we'd love to get your feedback. If you have a comment or a guest idea, please email us at TheLongView@Morningstar.com. Until next time, thanks for joining us.

(Disclaimer: This recording is for informational purposes only and should not be considered investment advice. Opinions expressed are as of the date of recording. Such opinions are subject to change. The views and opinions of guests on this program are not necessarily those of Morningstar, Inc. and its affiliates. Morningstar and its affiliates are not affiliated with this guest or his or her business affiliates unless otherwise stated. Morningstar does not guarantee the accuracy, or the completeness of the data presented herein. Jeff Ptak is an employee of Morningstar Research Services LLC. Morningstar Research Services is a subsidiary of Morningstar, Inc. and is registered with and governed by the U.S. Securities and Exchange Commission. Morningstar Research Services shall not be responsible for any trading decisions, damages or other losses resulting from or related to the information, data analysis or opinions or their use. Past performance is not a guarantee of future results. All investments are subject to investment risk, including possible loss of principal. Individuals should seriously consider if an investment is suitable for them by referencing their own financial position, investment objectives and risk profile before making any investment decision.)