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Do Active Funds Belong in the 'Too Hard' Pile?

Investors should quit assuming choosing an active fund is easy (or just quit), writes Morningstar’s Jeff Ptak.

I recently had the chance to visit with some users of our research, who asked for the one thing someone should look for to identify an active fund that will succeed in the future. It's a simple but very good question, one we get a lot.

The short answer is that there isn't any one thing, and that's why, to be blunt, most investors should probably index, not hunt for active funds.

Identifying a successful active fund in advance turns on numerous, subjective factors, and the importance of these factors can shift around over time. (More on that in a minute.) This alone is usually too much for most people to handle. Add to that the fact that even the winningest funds slump and investors, lacking the resolve to stick with it, bail. Take those two together and it argues that active-fund selection belongs in what Warren Buffett has called the "too hard pile." (Note: This also applies to advisors and institutional investors--who sometimes sneer at the impulsiveness of individual investors.)

Five Things? As most readers know, we have rated funds for a number of years, attempting to separate winners from losers in advance. We've distilled that approach down into five pillars--Parent, Process, People, Price, and Performance--which act as organizing principles for our research and culminate in the forward-looking Morningstar Analyst Ratings that we assign. We're asking ourselves questions like:

  • Parent: Is this an investor-centric organization or a business out for itself?
  • Process: Is the strategy prudent and how will it hold up if it succeeds and assets flood in?
  • People: How talented, committed, and deep is the team charged with managing the money?
  • Price: Is the fund's expense ratio low enough for the manager to add value?
  • Performance: Does it validate the stated investment process?

That's as close as we get to one thing--five pillars. As you can probably guess, each of those pillars touches a number of other factors that can determine how we'd answer each of the questions above. Thus, while we think the five pillars do well in codifying a uniform standard for evaluating funds, they're not exactly a short list. Five is more like 50.

(The Morningstar Rating for funds, which is backward-looking and entirely quantitative, turns on performance alone. However, we have never contended that this star rating is predictive; rather, we view it as a potential starting point for research.)

If I Had To ... Given that at this point some of you are probably screaming "OK, I get that, but if you had to choose one thing …" into your computer or mobile-device screen, I'll play along, but only to a point: I can't reduce manager selection to a single variable, but rather a very short list of factors that I would consider most strongly in assessing a strategy. That list follows below.

In considering these criteria, note that they're observable and quantifiable--you don't need to have access to the portfolio managers or be a fund junkie to make an assessment.

Expense Ratio Our own research has found that expenses are more predictive than just about any other variable. The reason is simple--expenses lower a fund's returns basis point for basis point. In a zero-sum world, that should place the cheap at a lasting advantage over the expensive. However, I tend to look at expenses for a second, often overlooked reason: They can tell you something about the way the fund firm thinks about investing and its responsibility to the investors it serves. Higher expenses tend to placate a fund company's desire for instant gratification. By contrast, lower expenses--which should pay off eventually in the form of better performance but not immediately--can signal that it's a firm that has a patient, long-term orientation. Put another way, if a fund company isn't disciplined enough to price its products for long-term success, what would give you confidence that it's disciplined enough to run money in a patient, thoughtful way.

Data point: Annual report net expense ratio.

Number of Funds a Fund Family Offers, and Number It Launched or Mothballed There is no right or wrong answer here. There are large complexes that have run very successful active funds; there are small firms that have brought out nothing but stinkers. What you're trying to assess is how a firm defines its circle of competence, as evidenced by the types of products it has, and has not, made available. Similarly, it can be instructive to know how disciplined a firm has been about launching funds in the past. Have they tended to be Johnny-come-latelies, chasing trends and blanketing the market in hot categories, or have they tended to hold the line? (The number of fund mergers and liquidations can reveal how disciplined firms have been over time.)

Data points: Fund inception and fund obsolete dates.

Portfolio Turnover The turnover ratio is the percentage of a portfolio that's bought or sold in a given year. (Given that derivatives tend to inflate funds' turnover ratios, turnover is more meaningful for stock funds than bond or alternative funds, where derivatives are used more heavily.) We recommend high-turnover and low-turnover equity managers alike. But my personal preference is for low-turnover managers. Why? Low turnover often tells you something about the underlying process--typically the manager is evaluating potential investments over a multiyear time frame, and the analysis that undergirds those ideas is also long-term-focused. It also can quell concerns that the portfolio manager is engaged in an artful form of keeping-up-with-the-Joneses, where trading the portfolio comes to be seen (wrongly) as a form of value-add. In investing, well-founded inaction is one of the simplest and best ways to stand apart from the crowd. A low turnover ratio is one way to find these patient iconoclasts.

Data point: Portfolio annual turnover rate.

Manager Investment When managers have sunk a decent chunk of their own change into the funds they manage, it stands to reason that they're going to approach the task in a more thoughtful, personally accountable way. That's why we fought for the disclosure of manager fund investment years ago, at a time the industry was bitterly opposed. There will always be excuses for why a manager doesn't eat his own cooking, but it's hard to argue that there's stronger evidence of a portfolio manager's alignment with shareholders than skin in the game.

Data point: Manager ownership level.

Manager Tenure Manager tenure goes last because it arguably provides the least information on its own. There are plenty of long-tenured portfolio managers who have crummy records; conversely, there are not a few relatively junior managers who have the goods. In other words, basing an investment decision on manager tenure alone is folly. Where it can be helpful, however, is in revealing qualities about a firm, while also illuminating how a fund has come to obtain the record it has. With respect to the former, it can be useful to know if a firm has tended to hold on to its investment professionals over the long haul, as that can yield a sense of company culture, including the fund company's willingness and ability to stomach underperformance. As far as the latter, one of the keys to piecing together a fund's record is knowing who had their thumbs on the scale at the relevant points. In other words, manager tenure can help to buttress conclusions one would draw in other areas, strengthening the assessment overall.

Data points: Manager start date and average manager tenure.

Conclusion Like any complex system, the individual components don't have much utility on their own. The real value is in how they come together with other elements to help us piece together a more complete and meaningful picture of a fund's prospects. And that, in turn, explains why there's not any one thing that successful active fund investing hinges on, but rather interrelated factors that should be evaluated separately and together.

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