This analyst blog is part of our coverage of the 2018 Morningstar Investment Conference.
When it comes to picking investments for a portfolio, there's plenty to consider: past and potential future returns, risk, and cost, to name just a few factors.
At the Morningstar Investment Conference, Morningstar director of manager research Russ Kinnel talked with three practitioners about how they evaluate managers and investments and how they know when it's time to part ways.
Panelists included Phil Huber, CIO of Huber Financial; Anna Snider, head of global due diligence at Merrill Lynch and U.S. Trust; and Michelle Ward, portfolio manager for Morningstar Investment Management.
Kinnel kicked off the discussion by asking how has the process of evaluating strategies and managers changed over the past five years.
In the past, said Snider, analysts would consider first and foremost things like relative performance and costs, and are you getting the return that you'd expect given the risk being taken. But today, as new product types have been introduced--particularly ETFs, interval funds, and alternatives that can provide very specific exposures--analysts are asking new questions.
"Is this the most efficient way for me to get exposure to a particular space? Today, I can invest in many more parts of the market through different structures with different pros and cons," she said.
Others agreed that the proliferation of structures has changed their analytical processes and that having more vehicles competing is a win for investors. Yet new products require education on their particular quirks.
"Interval funds provided access to a handful of asset classes we thought were useful," said Huber. "On the surface they look like mutual funds, but you need to understand the quarterly redemption features."
The panelists also agreed that they're looking for firms stacked with talent, not just one or two good managers.
For instance, all three practitioners stuck with PIMCO Total Return after Bill Gross' abrupt departure, and all own the fund today. Yes, they were concerned about the impact outflows might have on short-term performance. But ultimately, the depth of PIMCO's bench kept them on board.
"We knew the breadth and depth of the organization," said Ward. "We decided to stay the course because we felt what had made the fund very good was still very much intact. Yes, we spent a lot of time trying to understand how the unwinding of the portfolio due to outflows might look, but we felt comfortable that they'd be able to weather the outflows during the first several weeks. And when we looked at other options, we couldn't find another strategy we had more conviction in."
"Really know your managers and their firms; know more than just the name of the manager on the fund," added Ward. "Understand the resources behind it."
Among popular metrics, the panelists recommended using active share judiciously. Consultants love active share, noted Kinnel. You don't want high cost closet indexers, they say.
"It's an indicator, not a panacea," said Snider. "It's a metric that's well researched; it seems to have some potential indicative power in some markets. But it's not proven in the small cap or in international space, or in asset classes outside of equities."
"Over-relying on one data point is dangerous," warned Ward. "There are other ways to look at the value an active manager is adding over time. It's one data point that we'll look at."
The panelists touched on several other factors they examine. Kinnel likes to see managers heavily invested in their funds; he has found that there's some predictive value.
Ward, meanwhile, likes consistency metrics.
"Try to get away from trailing returns and focus on rolling returns; you can get too wrapped up in one trailing period," she noted.
Snider noted that she and her colleagues are starting to look at ESG factors. She argued that there's an investment and economic thesis around using these factors when evaluating companies.
"It's not about client preferences," she explained. "It's about, are you investing in companies that are going to end up preserving and compounding and be economically viable in the future."
Understanding what your manager owns is also important, especially given the increased use of derivatives in bond funds over the past decade.
"Understand how the manager is managing the risks, and what the limits are," suggested Ward.
"Demand transparency or don't invest," added Snider.
The panelists also noted that active strategies play a role in their portfolios.
"We're passive in equities with a blend in fixed income," said Huber. "Scale is helpful in fixed-income, and there are some really talented managers out there. Plus, the Bloomberg Barclays Aggregate Index is a poorly constructed index."
"When market-cap indexes reflect opportunity well, we'll go with passive," said Ward. "But in areas like high-yield bond and bank loans, the ETFs aren't cheap and you can get a comparably priced active manager to navigate land mines."
And how do these practitioners know when it’s time to cut a manager loose?
"We determine that at the beginning of a relationship, we spell out what would make us sell, which is a safeguard against behavioral biases," said Ward.
The panelists agreed that warning signs include changes to the process that can't be explained by management, vague explanations when performance isn't what you'd expect given the strategy, and increased turnover among analysts and trading staff.
"We view our managers as strategic partnerships," said Huber. "We're buying into a firm and a philosophy. But if a new option emerges in the marketplace that's a better solution, we’ll pursue it."