Research Funds Aren't All They're Cracked Up to Be

In recent years, analyst-driven funds have become more popular with fund companies, if not investors. Each year we see a few "research" funds launched.

The idea is to have a fund where analysts at the firm do all the stock-picking without being filtered through a fund manager so that their skills can drive total returns. Typically, these funds are run in a sector-neutral fashion in which each sector head doles out the assets to each analyst's picks. In a sense, research funds have been with us much longer than the recent trend would lead you to believe. American Funds has long handed a portion of most of its funds directly to analysts. It makes plenty of sense given how experienced its analysts are and how much money the firm has to manage.

Fund companies like these funds because it's a good way to give analysts greater responsibility and pride of ownership. It's a nice retention tool, and it gives firms real-money track records for their analysts. It also allows the company to offer another fund without requiring additional resources. If the fund produces strong performance, it is almost like found money for the fund company. The fund company can also point to strong results as a proof statement when touting the quality of its analyst staff.

As a fund researcher, I like how research funds provide me with a way to measure analysts' performance. Fund companies like to tell us how strong their research is, but they don't always back those statements up with hard numbers.

Should fund investors like research funds? The case is less certain. Experienced managers can add value through portfolio construction, by their own experience investing in a company or industry, or simply by knowing each analyst's strong suits and weaknesses and adjusting portfolios accordingly.

On the other hand, a fund manager can undo an analyst's good stock selection with bad timing or by making the wrong top-down moves, or by ignoring the analyst's advice. Also, an analyst-driven fund isn't vulnerable to the departure of one key person the way a fund with a sole manager is.

How Have Research Funds Performed?
Although I could think of some research funds with strong performance, I wanted to take a more systematic look at the group. It was important to include research funds that no longer exist so as to avoid being biased by the good funds that lasted. Poor performers that were liquidated or merged away are key to the overall picture.

I included all the ones I knew about. Then I searched for funds with "Research" in their names and read each prospectus to see if the funds really were analyst-driven research funds. There's no official designation of "research fund" in our database, so I may have missed a few funds but likely got most of them.

The results proved to be a little worse than I expected. The average Morningstar Rating for research funds was 2.62 stars--meaning they were a bit below average overall. For funds that exist today, I used their current star ratings as of the end of August 2012. For funds no longer around, I pulled their last star ratings before they were merged away or liquidated. As it turns out, there were a lot of duds. I noticed quite a few funds were merged away when they were 2 stars. I mentioned before that these research funds can serve as nice advertisements, but what if a research fund has poor performance? Presumably, the fund company has more incentive to get rid of such a fund than one run by a single manager because a research fund is emblematic of a whole organization.

Let's take a look at some prominent fund companies' research funds and what they tell us about the firms.

MFS
MFS has made more of the research format than anyone else. It has two U.S. equity research funds, one foreign stock fund, and even one bond fund. Collectively, they've done better than MFS as a whole. In fact, the Silver-rated  MFS Research (MFRFX) has the best five-year relative performance ranking of any MFS U.S. equity fund.

That has drawn investors' notice, and the funds have grown to $10 billion in assets collectively. We give  MFS Research International (MRSAX) a Morningstar Analyst Rating of Silver and  MFS Research Bond (MRBFX) a Bronze.

Since hitting a gully in the 2000-02 bear market, MFS has tried to reinvigorate its analyst work, and the results at these funds and the rest of MFS' equity funds indicate it has had success. Overall, the firm averages an impressive star rating of 3.43. The data suggest that MFS Research and MFS in general merit a look.

Janus
Like MFS, Janus has also tried to pull itself out of the early 2000s bear market by building up its analyst staff. The firm launched three research funds--one foreign stock and two domestic stock, but it later merged the two domestic-stock research funds because they were so similar. Janus' two research funds have been respectable performers:  Research (JNRFX) is 4 stars and  Global Research (JRGAX) is 4 stars for no load, though their load versions are mostly 3 stars. That is a bit better than the 3.2 stars averaged by Janus as a whole.

It's also an interesting sign of where Janus is headed. The idea of an analyst-driven fund at Janus would have been laughable 10 years ago as managers ruled the roost back then, but the firm  has since gone to great lengths to improve its analyst staff and broaden its coverage list.

Fidelity
This is a space to watch, as research funds are becoming a key part of Fidelity's lineup. Fidelity calls its research funds "Stock Selector." They offer  Fidelity Stock Selector All Cap (FDSSX), Fidelity Stock Selector Mid Cap (FSSMX), and  Fidelity Stock Selector Small Cap (FDSCX). It also has Advisor (the load equivalent) versions of two of the three. All but one of these funds rates 2 stars, but things are not as bleak as that sounds. The funds mostly switched to the research format two years ago, and their star ratings reflect some issues at the funds from before the change. So far, their returns as analyst-driven offerings have been respectable, but we rate the funds Neutral given the brevity of their track records.

I asked whether Fidelity Stock Selector All Cap would be the best representation of Fidelity analysts' output, and Fidelity said that the performance of the broader-ranging Select funds (Select is their name for sector funds) is a better measure. Certainly, they provide a much longer track record. Looking at nine broad Select funds covering industrials, real estate, consumer staples, energy, financial services, health care, materials, technology, and utilities, I found a more encouraging picture. The average star rating for those funds is 3.33, while the average star rating for the firm as a whole is only 2.8. In addition,  Fidelity Balanced (FBALX) uses a sector specialist approach and it has 4 stars.

A Better Model?
While the results are disappointing overall, a couple of quasi-research funds actually make a good case for themselves.  Columbia Acorn International (ACINX) and the Mutual Series funds have evolved into something close to, but better than, most research funds. These funds have blurred the lines between managers and analysts in a fashion that has retained most of the strengths of the official research funds but let go of some of the problems. These funds do have managers with some say over the funds' sector and country weightings, but their analysts have greater autonomy than most.

Columbia Acorn International has analysts and managers that focus on particular countries or regions, and the analysts have wide latitude to select stocks in their areas. It's a process that evolved after Leah Zell retired 10 years ago. Zach Egan and Louis Mendes still oversee the overall portfolio to avoid big bets, but they don't force regional or sector weightings to be in line with the fund's benchmark. That flexibility seems to work well for the fund. The weightings come from the analysts' and managers' bottom-up selections rather than any macro bets. Analysts are compensated based on how their portion of the portfolio performs versus a benchmark. Thus, they take ownership much the way fund managers do, and it's worked nicely as a retention tool.

Mutual Series funds' managers have a greater impact on portfolio construction, but the analysts are given quite a lot of say in issue selection. This team strength has helped the funds to perform well despite frequent changes in the managers' offices. Everyone at Mutual Series understands the firm's value discipline and invests in a similar fashion. As with Acorn, the funds have greater regional and sector flexibility and have used it well.

Mutual Series and Columbia Acorn International have been strong performers, particularly on a risk-adjusted basis. That their processes evolved naturally rather than starting with a mandate from top management no doubt has something to do with that success. And perhaps a fund with a manager who can guide the portfolio without standing in the way of talented analyst stock-pickers offers the best of both worlds.

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