Picking winning funds:
3 steps to improve your odds
David O’Leary
Morningstar South Africa
Director of Fund Research
P
icking winning funds is easy… after the fact. Identifying those
winners in advance is a lot more difficult. Even professionals
(myself included) often get it wrong. That’s because there
are no sure things in the investment world. There are only odds.
You can either improve your odds or worsen them, depending on
the way in which you go about selecting investments.
Given this cumulative experience with a firm, ask yourself some
of the following questions:
You can’t expect to hit a home-run every time you buy a fund.
That’s why it’s important to remain diversified. Your goal
should be to outperform in aggregate. At Morningstar we spend
significant time researching funds in the hopes of discovering
a few key insights to help nudge the odds slightly more in our
favour. If that sounds depressing, keep in mind that even a
small shift in odds can lead to huge changes in your long-term
compound rate of return.
•Can you say what’s distinctive about the firm, its people, and
its investment approach? If not, it probably doesn’t have a
clear competitive advantage.
But few people have the time or inclination to dedicate so much
time to researching funds. Below are three pieces of advice that
should help improve your odds of finding a winning fund; all
without having to quit your day job.
Stewardship
Taking a long hard look at how well a firm treats its clients should
be a big part of your decision to buy a particular unit trust. Since
unit trusts are often meant as long term investments, you’ll
want to partner with a firm that will treat you well long after
you’ve signed the original purchase documents.
Not only will you have a more pleasant experience investing with
a firm that treats you well, but their funds are likely to perform
better too. In the US, where we assign formal stewardship
grades (A through F) to funds and fund companies, funds that
receive higher stewardship grades tend to perform better.
A study in 2009 by researchers at Cornell and Binghamton
Universities found that US funds receiving an A or B stewardship
grade performed 1.6 percentage points better annually relative
to funds earning D’s and F’s.
One way to think of evaluating stewardship is to imagine you’re
conducting a character assessment. You can use any interaction
you have with the firm – conversations with company reps,
television interviews you’ve seen, public documents, the firm’s
website, etc – to paint a picture of its character.
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•Does it feel like the firm is selling you a product or providing
a professional service? In other words does it feel like you’re
dealing with your doctor or a used car salesman?
•How expensive are its funds relative to other similar funds?
Stay away from firms that gouge investors at every turn.
•Has there been a lot of turnover in its personnel ranks? Firms
that have a revolving door of employees coming and going are
typically poorly run organisations.
•How many funds does it offer? Is there a clear reason why
each exists and can you tell them apart? The more funds a
firm offers the more difficult it is to manage and the harder it
is to be an expert in all areas.
•Are you able to get the information you want about the
firm and its funds easily? If you still have many unanswered
questions after your research it’s probably because the firm
has chosen to be opaque or just doesn’t have its act together.
Either way, it’s a bad sign.
•Does the firm refer to its funds as “products” or “investments”?
You’re not buying a new pair of shoes. You’re entrusting them
with your hard earned savings. The language a firm uses can
speak volumes about its attitude.
Taking a long hard look at how well a firm treats
its clients should be a big part of your decision to
buy a particular unit trust.
Answers to these questions can tell you a lot about where the
firm’s true interests lie. Of course, it would be unfair to judge
a firm’s stewardship on any single issue. But cumulatively
questions like this allow you to create a mosaic that shows
whether a firm is focused more on salesmanship or stewardship.
we should all start demanding it. Knowing whether the person
who is caring for your life savings actually has some skin in the
game is important information.
Financial incentives
It’s also worth looking at whether a firm’s financial interests
are aligned with yours. In my view, the best way to ensure this
alignment of interests exists is to check whether the firm’s
managers invest in their own funds. What more incentive could
a company need to do well than having its own staff investing in
the same funds they sell to the public?
Past performance
It’s common for investors to look at past performance when
selecting funds. But instead of focusing on the level of a fund’s
historical returns investors should pay more attention to the
variability of those returns. In other words, the journey is more
important than the destination. The bumpier the ride, the more
likely we are to make poor decisions.
The table below demonstrates that the higher the co-investment
by a fund’s manager, the longer the manager sticks around, and
the better they perform. The data below is from the US; the
only country in the world where fund managers must disclose
their co-investment information. The far left column denotes a
fund’s star rating – a measure of how well a fund has performed
historically compared to other similar funds. The higher the star
rating, the better the fund has performed.
The field of behavioural finance has documented how volatility
plays on emotions such as fear and greed, and how these
often cloud our better judgment. In the world of finance, this
typically means buying funds after huge spikes in performance
(greed causes us to buy high) and selling when the fund
starts suffering big losses (fear causes us to sell low). It’s also
interesting to note that being aware of this phenomenon
doesn’t immunise you from it.
There is no requirement for firms to disclose co-investment
information in South Africa, but you can ask for it. Hopefully
one day regulators will mandate this disclosure but until then
Correlation between manager’s investment and fund performance
Fund’s Star Rating
Manager Tenure (Years)
Manager Investment
5
6.2
$300 000
4
6.3
$250 000
3
5.4
$160 000
2
4.6
$125 000
1
3.8
$110 000
Source: Morningstar
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10-year total return vs investor return
Fund A
10 Year Total return
15.1%
10 Year Investor return -1.5%
97
98
Annualised return (%) 12.7
34.9
5.3
9.9
Growth of $10, 000
00
01
02
03
04
05
06
120.1
-17.1
-27.8
-17.7
-43.8
20.9
24.4
8.8
72.4
118.9
69.1
45.6
52.2
51.9
57.1
63.2
Net inflows
Net Assets ($mil)
Source: Morningstar
The chart above demonstrates how insidious volatility can be. This
example from the US shows how a fund with a 10-year annualised
return of 15% can deliver a terrible investor return. An investor
return is a way of measuring a fund’s returns that places more
weight on periods where a unit trust has more money invested
in it and less weight on periods where fewer dollars are invested.
After all, what good is a fund’s excellent return if no one is there
to experience it?
In the example above, Fund A returns a whopping 34.9% in 1998
and 120% in 1999. However, the fund’s asset base is just $5.3 at
the end of 1997 and $9.9 million at the end of 1998. Throughout
1999 money continues to pour in and by year end it reaches
$72.4 million; just as the fund’s performance is peaking.
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The fund eventually reaches $118 million in assets under
management as performance starts dropping off a cliff and the
fund experiences double digit losses from 2000 to 2002 while
more people than ever before are invested in it. Investors then
run for the hills after the fund suffers massive losses and most
miss the fund’s rebound between 2003 and 2006.
When you add it all up, the fund’s reported 15.1% annualised
return translates into a 1.5% annualised loss for the average investor.
Unfortunately there’s no hard rule for how much volatility is too
much. The answer depends on each individual’s risk tolerance
and circumstances. But be honest with yourself about how much
you think you can handle and know that the more volatile your
portfolio the more prone you’ll be to making poor decisions.