Think Like a Fund Research Analyst: Tips for Picking a Passive or Active Fund

Finding great funds on Morningstar.com is easier when you know what the experts look for. In a recent Morningstar Investor subscriber-exclusive webinar, we asked two seasoned fund research analysts, Dan Sotiroff and Todd Trubey, to share their process. They provided an inside look at the frameworks they use to evaluate funds, offering actionable insights that can help simplify your own investment decisions and highlight what truly matters in fund selection.

In this 31-minute video, Dan kicks off the conversation with insight into his methodology for passive fund research, Todd discusses his approach to evaluating active funds around the 12-minute mark, and the Q&A begins at the 20-minute mark. 

Don’t have time to watch the video? Here are two workflows that you can put into practice right away, plus a roundup of top questions and answers from the webinar.

How to use the screener and site to research passive funds

According to Dan Sotiroff, a high-quality fund is cost-effective and follows sensible and repeatable processes. You can start your search by identifying cost-effective ETFs that meet your goals. The tips below are paraphrased from Dan's webinar commentary:

• Open the Screener tool
• Under Investment Type, select ETFs
• To find a high-dividend yield ETF, under Investment Type, set Morningstar Category to Large Value and Strategic Beta Group to Dividend
• To ensure the ETF is sufficiently large, select all of the boxes under Net Assets except for the top two (avoid <100 Mil and 100 Mil-500 Mil)
• Scroll to Fees and Expenses; in the adjusted expense ratio area, set the drop-down menu to “less or equal to” and type 0.1. In the turnover area, set the drop-down menu to “less than or equal to” and type 40. This will limit the search to ETFs that turned over 40% or less of their portfolio last year.
• This returns only a handful of ETFs, so it’s time to do some digging. You could visit the ETF’s web page or prospectus, or you could click through to the individual ETF quote pages on Morningstar.com. While on an ETF quote page, read the analyst’s summary and the text under the process section to get quick insight into how the ETF is selecting and weighting stocks.

To determine an ETF’s sensibility, visit the ETF’s quote page, and follow these steps:

• Click on the portfolio tab at the top of the page to look at the characteristics. If you started by screening for funds in the large value category, make sure that the quote page’s style box is in the large value category as well. You can look at the style box history if that’s been consistent over time by clicking on the “Historical” bubble above the style box.
• Next, scroll to the bottom of the page to look at the ETF’s holdings and diversification, and look for the number of holdings and the percentage of assets in the ETF’s top 10 holdings. For a strategic beta fund, to help reduce single-stock risk, you’d expect the fund to hold hundreds of stocks and have less than 35-40% of assets held in its top ten stocks.
• You’ll also want to check sector composition; ideally most of the sector weights would be fairly close to the category average and the index. You want to avoid a lot of lopsided exposure to one or two sectors, because that can add to the fund’s risk.

Finally, you can evaluate the repeatability of the ETF, to see if the fund consistently delivers what you want and expect.

• Right above sector exposures, you’ll find a graphic that looks a bit like a musician's mix table. Each column provides a way to look at the different risk factors that an ETF could be exposed to. If you’re considering a high-yielding ETF, you’ll want to focus on value and yield exposure. You can even change the lookback window – Dan often selects the five-year period.
• There’s one last check you can do to evaluate risk: Go to the risk tab at the top of the page. Change the lookback period to 10 years to see how the ETF has behaved over a long period. Check out the standard deviation at the bottom of the Risk & Volatility Measures table; if it’s been lower than or close to the category average or the index, there’s not much to be concerned about – if it’s higher than the average, you might want to do more digging to figure out what’s going on.

How to leverage the screener and analyst reports to find and evaluate active funds

When looking for actively managed funds, you want to know you’re getting the type of fund you want, preferably run by a strong management team using a sensible process. The tips below are paraphrased from Todd Trubey's webinar commentary, where he demonstrates how to narrow down the universe and conduct a typical analysis.

First, start with your initial screening process:

• Open the screener tool
• Navigate to the pull-down menus on the left-hand side of the screen
• When you open the screener, make sure “Investment Type” is on Mutual Funds, which is the default setting.
• Let’s say you’re looking in a relatively inefficient area where active management tends to do well. Todd demonstrates how to look for non-large-cap foreign equities such as those in Foreign Small/Mid Blend. To do that, go into Basics and set Morningstar Category to Foreign Small/Mid Blend.
• Morningstar's medalist ratings separate the wheat from the chaff, so if it has a Gold, Silver, or Bronze rating, that means it passes our muster. You can screen for that by going into Ratings and selecting Gold and Silver and Bronze.
• Once you've done that, as of this posting, you would see ~26 results, which is a pretty manageable number—especially given that we tend to see several share classes for each fund.

As mentioned earlier, we want to look for actively managed funds.

• You have to use a bit of a trick to get to those.
• Click Data & Columns.
• Then, underneath Funds, Click Basics.
• In the center column, you should see Index Fund. That helps you pinpoint a passively managed fund. That’s not what you're looking for in this exercise, but you can use it in reverse.
• As you can see when you scroll to the far right and sort by Index Fund, three good funds are index funds. The others are not index funds, which means that they are active funds.
• At this point, you might want to rank rather than screen to find something interesting. It’s often a good idea to look at fees. You can rank by Fee Level Distribution, and you will see quite a few low fee levels.
• Some of those low-fee funds are passively managed, but a name that might pop out is Goldman Sachs.
• In Todd's example, he gives the Goldman Sachs Intl Small Cap Insights fund a look. Click on that, and you’ll go to the fund’s quote page.

• At the top, before you look over the analyst’s work, you'll see some key statistics, including the fact that it has an expense ratio below 1% and it is open to new investors with no minimum.
• The Summary section boils down the most important things in about 500 words. The sections below dig deeper into those points, including Process, People, Parent, Performance, and Price.
• After reading through that fund report, if you’re not sold, return to the screener tool. Maybe you prefer funds with lower turnover, which tend to be more tax-efficient, and often more long-term oriented. So once you've gone back to your screener, use data & columns to add turnover ratio to your view. Sort your view by turnover ratio to see if you can beat the ratio of the previous fund you were researching.
• The screener can help you specify what type of thing you’re looking for, and you can use the work that the Morningstar analyst has done to pick from the offerings that meet your criteria.

Q&A recap

The highlights below are paraphrased from the questions submitted by Morningstar Investor subscribers, and Dan and Todd's responses to those questions:

1. What is the difference between a star rating and a medalist rating? A star rating is historical, it’s quantitative, it looks backwards in time, and it’s an achievement test showing what it has done before; the medalist rating looks forward, it has more qualitative aspects to it, and it’s more like an aptitude test like the SAT or an IQ test. Both are good starting places to start looking at a fund, but neither are an end point.
2. Thoughts on active vs. passive given the low success rates we’ve seen with some active funds? The most important thing is, this doesn’t have to be a binary choice – you can have active funds and passive funds all together in your portfolio. There are some areas where I tend to go passive and that’s because they’re very efficient markets, really hard to beat. Think US large cap blend, S&P 500 or Russell 1000, that’s a great place for an index fund. Then for active funds, the further out it is and the more efficient the market, the more really smart investors can get some extra alpha, some outperformance. You want stuff that’s really well managed, low cost, and importantly, you have to be willing to hold it over a really long period of time, ideally 5-10 years, or preferably longer, to let compounding do its work over time.
3. Should I consider active funds in the bond market categories? You see more than half of active managers outperform in some of their core categories, like corporate bond, intermediate core, and high-yield bond, and that’s because it’s such a massive universe that you can really do some good selection if you have a strong team. Now, for those, the benchmark is treasuries, so the hurdle rate is pretty low to start out with, but we do tend to see fairly high success rates over 10, 15, 20 years.
4. When a fund substantially outperforms, do you downgrade its future prospects? The simple answer is no – it is not an automatic downgrade, but what you have to do is think about why did it outperform over the short term, does that mean that it’s had the wind at its back (oftentimes it has), but what we’re doing on the active side when we’re trying to analyze funds, is we’re looking at repeatable processes that can do things again and again, we’re looking at patterns; does it tend to outperform during bull markets? Does it tend to outperform during bear markets? It’s rare that they do both. Whenever you’re looking even two to three years back, and try to forecast a few years ahead, you’re in danger of market timing. Now, the question was posed in the right way, that you want to kind of lean against what has most recently happened, but you don’t want to give up on something that has really good long-term prospects.
5. I often hear "buy and hold" for the long term, yet it seems like we should rebalance every year based on returns. What are your thoughts on how often we should rebalance? The important thing is that you rebalance periodically, pick a frequency, whether that’s every 6 months or every year. This is to keep your portfolio in check. And if you’re still putting money into the portfolio, you can often achieve a rebalancing just by tilting where you’re feeding the portfolio. You want to have a game plan, you want to have an asset allocation that you’ve set as your target, and then if, say, bonds are a little light in that asset mix, you just feed those bond funds with inflows in your 401K or your IRA or wherever you have your assets. Likewise, if you’re in the withdrawal stage, in retirement, you can use those outflows to do the same thing; you take from what has done well and maybe leave the stuff that has performed a little less well. Using cash flows is a really cost-effective way of doing that in retirement.
6. What is the best risk measurement: Sharpe, Standard Deviation, or other measures? They’re all important. We look at them all, because sometimes you will see a fund that looks really good on one metric but not so good on the others, and you want to figure out why that might be. You can have a fund that has a really high standard deviation, which means the volatility of returns is high, but if the Sharpe ratio is pretty good, it means that over a period of time, it has rewarded you with returns. And there’s often more insight you can glean by digging a little deeper.
7. What are reasonable fees for active mutual funds and ETFs? Can you give us a ballpark? It depends on category and it also depends on channel. If you’re using a financial advisor, that’s going to be a very different answer from if you’re a DIY investor, and the passive approach is also very different. In the active fund research segment, Todd showed how you can filter by low, below average, and average; all of those are as compared against peers. And for passive funds, particularly the core categories like large cap blends, oftentimes you’re paying single basis points there, and that’s sort of the threshold, that you want to be under 10 basis points for something that’s in the large value category if you’re just looking for a generic index tracker or even a high-dividend yield ETF.

If you're not currently a Morningstar Investor subscriber, start your free trial today.

Explore more of Morningstar’s fund investing strategies with Morningstar FundInvestor and Morningstar ETFInvestor. Subscribers get exclusive monthly issues, model portfolios, watchlists, and more.