What Do Investors Seek in a Fund?

Christine Benz: Hi, I'm Christine Benz for Morningstar.com and I'm here at the Morningstar Institutional Conference. Lee Davidson, head of global quantitative research for Morningstar, is here to talk about what factors drive fund flows.

Lee, thank you so much for being here.

Lee Davidson: My pleasure.

Benz: You run a lot of research at Morningstar. Your most recent study looked at the different factors that might drive flows into mutual funds. Let's start by discussing the methodology that you used. You examined a specific time period for U.S.-domiciled funds and then another time period for foreign-domiciled funds. Let's discuss that and what types of funds you examined.

Davidson: Absolutely. So, we looked at 71,000 mutual funds globally in this study. In the U.S. we were able to go back to 2003, beginning the sample in that time period and extending it to 2015. Outside of the U.S., for funds domiciled outside the U.S., we were looking 2008 to 2015.

And really what the goal of the study was, was to isolate specific fund attributes that investors seem to reward/value/prefer. So the regression that we ran isolates these particular features at different points in time and tries to estimate did investors prefer this or that fund characteristic at certain points in time.

Benz: So, one theme that you often hear in the realm of fund flows is that investors gravitate to funds with strong past performance. Did your research bear out that general thesis?

Davidson: Absolutely. Performance was without question probably the leading driver, but we weren't just looking at returns. We were looking at multiple elements, multiple dimensions of returns. So, we looked at a few different metrics for that. So, we looked at alpha, more kind of in line with managers' skills where investors able to pick up on skilled managers versus unskilled managers. We also looked at strategic beta or smart beta style tilts. So, do investors prefer value type returns, do they prefer growth, do they prefer small cap, large cap, momentum? Then on top of that how does category relative ranking performance kind of fit into that equation. So, we observed strong preferences for higher-rated funds according to the Morningstar Star rating compared to lower-rated funds. So there is absolutely preference for higher-performing funds.

Benz: And you did not take into account exchange-traded fund flows?

Davidson: That's right. So, this study was exclusively limited to open-end mutual funds.

Benz: Let's take these category-by-category. U.S. equity, let's talk about some of the key drivers of investor flows based on your research. Performance was important here but one of the big interesting things was that low fees were also a key driver as well as whether a fund was an index fund, which kind of goes hand-in-hand with low fees.

Davidson: So, without a doubt, performance was an important driver in the U.S.-domiciled equity funds space. We saw preferences for higher-rated Star-rated funds, alpha, and we also saw preferences for strategic beta. But those oscillated through times. So, we saw that value exposure, for example, was preferred for quite a long time until recently in the last five years there has basically been no preference for value funds. We also found that fees, like you mentioned, were definitely an element in investor decision-making. So, higher-rated funds--I'm sorry--more expensive funds received outflows at the expense of lower-rated funds. And this was an independent driver than index fund. So, usually we kind of conflate the two ideas that index funds are cheaper and so therefore they are kind of going over there investing in index funds for the fee element itself. But we found that these effects were actually additive. So, index funds were a preferred vehicle to just invest in the equity markets regardless of the cost of the product itself.

Benz: Foreign equity performance is also important here, but less of a preference for low-fee products?

Davidson: This was definitely one of the most surprising results of the study. So, typically, if you're thinking about, like you're shopping for a car, right, you would see all of these attributes about the car and if everything is the same about the car, you would expect if one cost less then everyone would gravitate toward the product that costed less, the car that costed less. But outside of the U.S. when we run the study and we are controlling for a host of fund attributes, we found that there was virtually no preference for what the cost was. So, European investors, investors in Canada, for example, really did not use the net expense ratio equivalent data point to drive their flow decisions to where they are investing their money. That was very surprising.

Outside of the U.S. in the equities space we also saw similar patterns with regards to preferences oscillating through time for strategic beta exposure, similar preferences for kind of well-performing funds historically, and we definitely--one of the unique things about the ex-U.S. market, was that larger fund families tended to have scale benefits but we did not find that present in the U.S. data.

Benz: How about fixed income? You saw in that group as well among U.S.-domiciled funds a very strong preference for low fees.

Davidson: That's right. In the U.S.-domiciled fixed-income market, low fees really mattered. Alpha, manager skill, mattered significantly, arguably the largest driving variable in any of those kind of sub-samples that we looked at. There was also quite a bit of a preference for equitylike exposure, which is strange if you are thinking about fixed income. But people were really gravitating towards things like high yield and convertible debt in addition to credit exposure. So, those were some of the driving forces there that we saw.

Benz: It was kind of yield-starved environment the time period that you examined. So, it probably had to do with investors gravitating…

Davidson: Which probably makes sense, absolutely, yeah.

Benz: One trend that you observed is an increased interest in socially responsible mandates, ESG mandates. Let's talk about that.

Davidson: Yeah. So, Morningstar has been collecting a data point that's self-reported by funds to us called Socially Responsible Indicator, SRI. So, we looked at the effect of that. Was there any difference in average flows through this time period that we're examining between those that claimed that they were investing in a socially responsible manner and those that were not. And we found that funds in the U.S., in Europe and Canada, were rewarded with higher flows than what had been justified by their other characteristics according to this kind of self-reported socially responsible index figure, which is very interesting.

I think when you look at the time series of this, too, from January 2005 to January 2011, this was tremendously high. Typically on average we're seeing 1% extra growth per month for funds that claim to be investing in a socially responsible manner. Then after January 2011 this effect kind of dissipated and only recently in the past six months we've seen it kind of spike back up. So, this seems to be on people's minds and it is definitely something that we want to monitor going forward.

Benz: Lee, fascinating research. Thank you so much for being here to discuss it with us.

Davidson: Thank you. I appreciate it.