Understanding Mutual Fund Competitive Advantages

In essence, the Morningstar Medalist rating is about competitive advantages. If we think a fund has enough competitive advantages to outperform its peers, we give it a Morningstar Analyst Rating of Bronze. If it has enough advantages to have a good chance to outperform its benchmark, too, we rate it Silver or Gold.

Our analysts spend the bulk of their time assessing whether a fund has competitive advantages.

Some advantages endure and some erode over time, so it requires a close watch and a mind open to change. Reaching your investment goals is a lot easier when you invest in funds with competitive advantages because you improve your chances for outperformance. (Building a sound plan and sticking to it are also huge parts of meeting your goals, of course, but I'm focusing on the fund-selection part here, as I do most of the time.)

The asset-management business manages trillions of dollars, and even with fee competition, it is a hugely profitable business for the more successful firms. That makes competition fierce, and advantages can erode. It's worth noting that the mutual fund industry is only one large part of the investment industry; hedge funds and sell-side research are also big challenges to a fund's competitive advantages.

Sell-side analysis might not sound like much of a challenge if you are familiar with its rather poor record on buy/sell recommendations and the fact that it is heavily skewed toward buys. However, the sell side is quite good at tracking business developments and new products, so it is hard for the mutual fund side to unearth information that hasn't been priced into a stock.

Another aspect that makes this challenging: Most funds have smart managers who went to good schools. Many of them have managers with decades of industry experience. Those features alone are not enough to make a competitive advantage. A competitive advantage requires high levels of skill and experience and a process that is well suited to make the most of the manager and the firm's strengths. Culture is crucial to getting the best people and making good use of them. Many Neutral-rated parents and funds feature smart people but an ever-changing cast of characters. Churn in the analyst and manager ranks makes it much harder for the members to get on the same page and produce outperformance. Departures are also investment professionals' way of signaling to the outside that all is not right at the firm. On the other hand, strong cultures have very low turnover because they can be quite selective, and they have incentives that make managers, analysts, and traders want to stay there for life.

In short, culture is one of the strongest, most sustainable competitive advantages in the investment world. It's incredibly hard to rebuild a strong culture at a broken firm or even make one from scratch no matter how big the budget.

Understanding these advantages will help you make the most of a fund and provide a useful lens for deciding whether to hold on to a fund. One piece of this is very simple. Low costs are a big advantage, and high costs are a big disadvantage. The rest is more challenging to assess, so I'll mostly focus on that here. 

Besides costs, advantages can be firm-level or fund-level. The fund level contains the People and Process components. All are related and important. Let's look at some examples.

 PIMCO Total Return (PTTRX)
Firmwide: PIMCO's trading desk, technology, analyst depth, access to bond issuers, and experienced management are elite and very tough for competition to match. Trading is much more important in fixed income because it occurs largely off exchanges. PIMCO has expertise in derivatives, and that skill was on display when the firm handled record redemptions at this fund without appearing to give up any returns in the process.

Fund level: The fund does a strong job of combining macro, sector, and issue selection to build its portfolio. It starts with a trio of experienced, skilled managers, with Scott Mather in the lead, teamed with Mihir Worah and Mark Kiesel. Each has a strong track record on his own and his own area of expertise.

 Fidelity Total Bond (FTBFX)
Firmwide: Back in the mid-1990s, Fidelity gave up bold macro calls in its bond funds for two reasons. First, it wasn't very good at them. Second, people want dependability from their bond funds, and that wasn't the way to do it. Since then, Fidelity aligned its bond funds with the firm's strengths in security selection and technology. The funds generally kept duration close to their benchmarks and instead had analysts and quantitative analysts build outstanding tools for security selection using humans and technology. They don't always beat their benchmarks, but they rarely take big losses.

Fund level: Ford O'Neil is a seasoned investor who has done a fine job harnessing that issue selection to produce strong returns here. He taps research on mortgages, investment-grade credit, Treasuries, high-yield, and emerging-markets bonds to build a wide-ranging portfolio. Thus, you have a good marriage of firm strengths and fund strategy.

 Vanguard Total Stock Market Index (VTSAX)
Firmwide: Vanguard's mutual ownership structure is one of the great competitive advantages in the fund world. It means employees are working solely for shareholders and that funds will charge an at-cost expense ratio. Over the years, those advantages have made Vanguard's funds the cheapest, and they've meant that Vanguard is more willing to clearly explain its risks and other drawbacks than other funds are. No one else can get that structure. Having the most money under management also gives Vanguard unmatched scale.

Fund level: Here's the tricky bit. An escalating fee war in index funds means Vanguard is not always the cheapest index fund in a category. In big categories for passive investing, such as a total market fund, many of funds are super-cheap. Competitors like Fidelity, iShares, and Schwab are often as cheap or cheaper than Vanguard. But that's OK. 

When you buy an index fund, your goal is to keep costs low and get returns that are just shy of the market's. This fund's fees have come down and so, from that perspective, Vanguard and other similarly priced funds offer a better deal than ever. Yes, Vanguard has lost its competitive edge versus some passive competitors, but its advantage over actively managed funds and many other investment vehicles is very much intact.

 T. Rowe Price Blue Chip Growth (TRBCX)
Firmwide: T. Rowe Price has one of those strong cultures that competitors envy but can't match. It helps that T. Rowe hasn't gone through a bunch of mergers the way some big players have. But even more, it helps that T. Rowe has always been shareholder-oriented. Its funds stick to their strategies and are very clear about their goals. But most of all, the firm has steadily improved the quality of its people. Many stay until retirement, and that means they are thinking long term rather than going for the highest returns or most assets to make the most money quickly. Its strong analyst team has helped its funds produce strong performance across the board.

Fund level: When T. Rowe's top managers come together with good analysts, you can get results like this. A growth manager faces the challenge of competing with all the Wall Street analysts covering growth favorites like  Facebook (FB) and  Apple (AAPL). Yet through judgment, a long-term focus, and experienced analysts, Larry Puglia has stayed ahead of the competition.

 Matthews Asia Dividend (MAPIX)
Firmwide: Matthews has a clear focus. All of its funds invest in Asia, and most have risk-aware strategies that steer clear of extremes in performance. That focus has helped it build a strong team of Asia analysts and managers. Other firms' interest in Asia tends to wax and wane, but this firm stays focused. It probably helps that it is too much of a niche strategy for the fund giants to try.

Fund level: This fund brings Matthews' research to bear in a pleasing form that works for investors. Going after dividends steers the fund away from the most speculative fare and instead toward companies with healthy balance sheets.

 Alger Small Cap Focus (AOFAX)
Firmwide: Alger is a decent firm with a consistent growth focus across the board. However, we rate it Neutral as it hasn't really stood out on stewardship, and I don't think Alger funds really have a head start on the competition.

Fund level: This fund boasts an excellent manager and a strong strategy. Together with a modest asset base, the fund has a real edge on the competition. Manager Amy Zhang came from Brown Capital Management where she had worked for 12 years on Gold-rated  Brown Capital Management Small Company (BCSIX). The Brown fund and this one have similar competitive advantages. Both funds look for fast-growing companies with strong balance sheets. Both take a patient, low-turnover approach that stands out in a momentum-driven area. A four-analyst team supports Zhang. That might sound small, but it's fine for a focused small-cap fund.

(This fund is set to partially close to new investors at the end of the month.) 

 Baird Aggregate Bond (BAGIX)
Firmwide: It's hard to separate family and fund level here, as Mary Ellen Stanek's fixed-income team dominates the fund complex. The family took a different route from PIMCO by keeping things simple and avoiding esoteric derivatives and currency bets.

Fund level: Stanek has built a strong team to run conservative strategies. Avoiding derivatives and other exotic fare means it can stay in its zone of competence and run a smaller staff than the bond giants of the world. Very low fees of 0.30% on institutional shares further ensure it can produce competitive returns without taking on big risks. In general, the higher a fund's fees, the more risk it will take on to overcome those fees. A fund's income stream must pay expenses first, after all, and the rest goes to shareholders.

 Artisan International Small-Mid (ARTJX)
Firmwide: Artisan is well-positioned to poach great managers. It has a unique pitch: Come to Artisan and you can have entrepreneurial profits and control over your operation without having to handle back-office, compliance, or sales work because Artisan will do that. The firm hunts for great managers who are ready to make the leap and young enough to have a long runway. It has worked remarkably well, and now the firm boasts an array of strong boutiques.

Fund level: Rezo Kanovich is the latest hire for Artisan. He came to Artisan from  Invesco Oppenheimer International Small-Mid Company (OSMAX) where he built a brilliant record. He took with him two analysts, so he hit the ground running. The fund's small asset base and Artisan's record of closing funds give it a lot of appeal.