Measuring the strength and weakness of an investment team is one of the core responsibilities of Morningstar’s Manager Research team. Good investment teams are appropriately staffed for the strategies they manage, demonstrate good judgment over time, and act in the best interests of their clients. A poor investment team may be mis-staffed, misaligned, or misbehaving. The difference can have a material impact on investment outcomes.
Indeed, the People Pillar rating is an integral part of the Morningstar Analyst Rating. The score we assign to the People Pillar accounts for 45% of the overall Analyst Rating, equal in importance with the Process Pillar rating. The Parent Pillar receives a 10% weight, while performance is not scored at all.
So, let’s take a deep dive through the People Pillar rating, especially as it relates to bond funds.
Morningstar analysts collect a set of basic data and information when assessing a strategy’s team. This includes things like the experience and backgrounds of the portfolio managers and analysts; turnover; analysts’ coverage responsibilities; compensation structure; and portfolio manager fund ownership, if any. Every analyst collects this data directly from the asset manager and through Morningstar’s own data and products, supplemented with publicly available sources such as filings, press releases, LinkedIn, and occasionally even local newspapers for stories that don’t rise to the level of financial media.
This information is necessary but not sufficient for scoring the People Pillar, however. The People rating is not a checklist or a participation award, and a bigger team is not always better. We’ll spend most of this article examining the nuances that analysts must consider.
Certain factors, such as team size, mean different things depending on the sector and style of the fund in question. For example, in large, liquid markets where data is plentiful, such as rates, Treasuries, and agency mortgages, team size tends to skew smaller. In areas where the market is fragmented or research requirements are intensive, such as munis, leveraged finance, and structured credit, team size tends to skew larger. This reflects the requirements to manage those portfolios rather than an indication of a strong or weak team.
To take this a step further, we will occasionally rate the same team positively on one strategy but average on another. This often indicates a mismatch between the team and the strategy; perhaps we think they are eminently capable of managing a high-quality core bond mandate, but less capable of running a concentrated leveraged finance fund, especially relative to dedicated competitors in the leveraged finance space.
A similar example arises on teams in which corporate credit coverage--including investment-grade, high-yield, and even bank loans--all sits with the same analyst team. In our view, this structure works best on core and multisector-style products in which both investment-grade and high-yield are part of the opportunity set, and the allocation back and forth across the quality spectrum may play a significant role in fund performance. In those cases, it can be powerful when analysts are quickly able to judge relative value opportunities across the market.
However, we may be less comfortable if that same team is also running a dedicated high-yield bond or bank loan strategy. Now the resources and time required to effectively manage this broader range of strategies have expanded, in addition to the fact that running dedicated versus multisector portfolios requires different skill sets. That doesn’t mean it’s impossible for such a team to receive a positive rating on the dedicated fund--simply that the bar is generally higher.
Team Size and Experience
A large team with experienced members is nice to see but not a standalone reason for a Positive People Pillar rating. A better place to start is with the question, “Is this team appropriate for this strategy?” In addition, it’s common for asset managers to present the full investment organization when only a small handful of professionals are responsible for the strategy in question.
For example, that big investment organization might be largely composed of corporate credit analysts, but the strategy in question is dedicated to structured credit or mortgages. This does not preclude a positive rating; it simply narrows the focus to individuals most involved in the management of that fund. If the firm’s structured credit resources are too thin or inexperienced, the fund is unlikely to receive a Positive People Pillar rating.
In other cases, a small team may comfortably earn a Positive rating. This is most common for teams that are highly specialized and dedicated to a single strategy with a manageable asset base, especially if the backgrounds of each team member are supportive of that strategy. One example of this is Artisan High Income APHFX, which has an Above Average People Pillar rating. The team is modestly sized--one portfolio manager, four analysts, three associates, one trader, and one data scientist--but each has a background conducive to running a concentrated, idiosyncratic high-yield bond portfolio.
A common reaction among both investors and newer analysts is to assume that any turnover is bad turnover. As analysts, our job is to understand where the exceptions lie and what the story is behind those exceptions. In the case of turnover, it’s important to understand who left the team, why they left (this is often nonpublic and communicated to Morningstar off the record), and who they were replaced with.
Let’s look at a few different examples:
- A large team has consistently high turnover every year, but it turns out that those are junior analysts going through their rotation. This isn't a bad thing, and our rating should incorporate that churn, usually by discounting the impact of those junior analysts and focusing on the (hopefully more stable) core of senior analysts.
- Over the course of 18 months, a large team sees a tiny handful of departures. It doesn't rise above the level that the firm experiences in a normal period, and all the departing professionals were in less-public roles, so it's easy to miss. But it turns out all those individuals were long-tenured insiders who played a significant role in building up the team to its current status. Key departures like this can indicate a culture or management change, or the potential launch of a competing team. The departure of even a small number of key players is often a negative.
- The investment team consistently loses one or two mid-level analysts every other year. It doesn't seem like a big deal and the firm always has a replacement ready to go. It's possible this is simply the natural churn that comes in any industry. But it's also possible that all the departing analysts reported to the same person, or they were all women or minorities. As analysts, our job is to look for patterns and commonalities, and to get as close as possible to the truth.
Alignment is a catch-all term to describe monetary incentives and other factors that indicate how aligned the investment team is with shareholders. The most frequently cited example of this is portfolio manager ownership in the funds they manage, which is publicly available and surfaced through Morningstar.com, among other sources. Manager fund ownership isn’t always a perfect encapsulation, as we may give them credit if they have exposure to the strategy through an internal account. Furthermore, there are cases where the strategy in question may be inappropriate as a core investment holding for that portfolio manager.
Monetary incentives also include firm-level ownership (if applicable) as well as compensation structure for both analysts and portfolio managers. As a rule, Morningstar prefers bonus structures that are more heavily weighted to longer-term lookbacks (five-plus years), a longer-term vesting cycle paid directly into the funds managed, and (less common) include a firm equity component. Shorter lookbacks (one to three years) are less desirable as we believe they can encourage short-term thinking and performance-chasing.
Finally, there are situations where the investment team may have minimal fund ownership but substantial firm ownership. This arrangement doesn’t necessarily ensure an alignment of interests with investors, since it is possible for firm to be successful through asset gathering while the performance of the funds themselves languishes. On the other hand, we have traditionally had a favorable view of owner-operator firms and privately held firms in which the investment team has a sizable ownership stake. Such firms tend to score positively on their Parent Pillar rating.
Judgment is the most qualitative part of our assessment. We attempt to analyze portfolio managers’ decisions over time to answer questions such as: Are they disciplined in executing their strategy? Do they get calls right more often than not? Are they risk-conscious? Do they pay attention to valuations? Are they transparent with investors? Do they learn from their mistakes?
It is also worth highlighting that portfolio managers’ charisma matters little in our assessment. A pleasant conversation with a charismatic manager may yield little useful information, while an awkward conversation with a nervous manager could yield a wealth of insight. We are not assessing their public-speaking skills--we’re assessing their ability to manage money. Very often these are two different skills, and whether I enjoyed the conversation should have zero bearing in how I rate a portfolio manager.
I hope this helped illuminate much of the thinking that goes into the People rating of bond funds. Within our model, the People Pillar is just as important as the Process Pillar. There are no participation awards for having an adequately staffed investment team, and our assessment is not a simple checklist. A strategy’s People and Process Pillars are often inextricably linked and the nuanced story behind the team is much more important than the numbers. As always, the devil is in the details.