In search of a star performer
Defining great fund management is a difficult task but Morningstar's new rating system is a good place to start, writes John Collett.
Defining great fund management is a difficult task but Morningstar's new rating system is a good place to start, writes John Collett. While it's easy to say what a good fund manager does, it's harder to pin down the ingredients that go into it. Researcher Morningstar puts it down to the five "Ps": people, process, performance, parent and price. These five key factors are used by the investment researcher to rate funds and provide a useful guide for investors.One of the worst things an investor can do is constantly switch in and out of funds chasing this year's best performer. That's because even the best-performing managers can suddenly lose their mojo."A rational investor would not just look at the best-performing stocks and support them blindly," a research manager at Lonsec, Paul Pavlidis, says."It is pretty much the same with fund managers. There is a lot of research out there that shows that a fund manager may perform well for a period but at some point will hit a tough period."The returns of even the best-performing Australian share funds are underwhelming at present.That's because the past five years, since the start of the GFC, have been among the worst of any five-year period on the Australian sharemarket.During this time, the Australian sharemarket has produced an average annual return of minus 2.1 per cent. Any manager that has done better than that, after fees, has done well (see table).But what is in the past cannot be undone. What investors need to know is which managers are the most likely to perform the best in the future.Recently, Morningstar changed its rating process to put more emphasis on the likelihood that a fund will outperform the market in which it is investing over the long term.Morningstar's highest rating is "gold" followed by "silver" and "bronze", as well as "neutral", "negative" and "under review". The forward-looking ratings mean a fund with ordinary performance may still receive Morningstar's highest rating if the researcher believes the manager is likely to produce higher returns in the future.As well as being able to select good managers, it's also important to be able to recognise the warning signs of when things start to go wrong, before investment performance is affected.For the researcher it is more than just picking the winners. "We try to avoid the managers with the systemic issues that cause those bad periods [of performance]," Pavlidis says.GOOD PEOPLEPavlidis says the most important factor is people. "If you have intelligent and well-motivated people, that's a really good start," he says.But if the people running the money are not so good, you can end up with a fund that just delivers market returns, or less after fees, he says.At MLC Investment Management, which selects combinations of managers to run its multi-manager funds, the emphasis differs slightly."We start at the highest level and look at the organisation [employing the fund managers]," the head of debt assets research at MLC Investment Management, Stuart Piper, says."If we cannot tick the organisational box we do not hire them, even if they do have really good people and performance." Changes at the top of the organisation can quickly destroy those good performances, Piper says.Researchers say there are few examples of when a fund has been bought by a financial services institution or merged into a larger business where the fund managers' performances have not suffered."Most takeovers have poisoned the investment performance," the co-founder of researcher Zenith Investment Partners, David Wright, says.Acquirers of fund managers have learnt from the mistakes of others and are a lot smarter now in how they go about it, he says."But there have been some disasters in the past - a lot of disruption and a lot of staff departures," Wright says.Ownership and personnel changes are the main reasons for a good performer turning into an also-ran.New owners may put in place a reporting structure above the senior investment management staff, who are used to working with a minimum of bureaucracy.Marketing staff of the new parent may start exercising more influence on how the money is managed. It could mean the fund managers are required to keep accepting money in the fund to generate more revenue from investment management fees, when it has been shown that a fund manager's performance can slip when they are managing too much money.The marketing staff may put pressure on the fund managers to open new funds, to capitalise on an investment trend or fad that is flavour of the month.IN WHOSE INTEREST?Alignment of the interests of the fund manager with their investors is also essential to good performance, researchers say.Often that alignment of interests can be better achieved at a boutique fund manager, where the business is owned by the people managing the money.They often charge performance fees, which are only paid on reaching certain performance targets.Large managers owned by the banks and insurers take their investment management fees as fixed percentages of funds under management - though most have some funds that charge performance fees.Boutique fund managers have a much greater stability among their senior investment staff, as they are usually also co-owners of the business.Renowned investor and the co-founder of Boston-based fund manager GMO, Jeremy Grantham, wrote in his newsletter recently that a lot of the behaviour of fund managers is driven by career risk rather than investment risk. The prime driver is to keep their job and that means never being wrong on their own. They tend to invest in a way that closely matches the market. "This creates herding, which can drive prices far above or below fair price," he says.Performance tables show that the best performers are the boutique managers and the institutionally owned managers who mimic the best practices of boutique managers. Many of the big financial services companies, such as the banks and insurers, have learnt from the experiences of the boutiques and given their fund managers much more latitude to manage the money.Many of the first generation of managers to set up shop on their own, such as Kerr Neilson of international shares specialist Platinum Asset Management and Anton Tagliaferro of Investors Mutual, have enviable performance records over many years and many different market cycles.While the researchers have their processes and scoring systems when rating managers, they all ultimately make the final call on the contact they have with the managers."The review meeting is the pivotal part of what we do," Pavlidis says. "We need to meet the managers and understand how they operate, not just how they say they operate."There are the people, the resources, research inputs and risk management, but gut feeling also comes into it, Pavlidis says. Piper says there is a confidence or lack of confidence aspect to it and he has to make a judgment in the end. "You have the numbers to back it up and you have done the due diligence but, in the end, you make a judgment about these things," he says.PICK OF THE CROPInvestors could do worse than take note of the favoured picks of experienced researchers.Wright says that during the global financial crisis, he saw how well the old hands handled the market volatility much more confidently than others.He was struck by how well Australian shares managers such as Matt Williams at Perpetual, Paul Xiradis at Ausbil Dexia, John Murray at Perennial and Crispin Murray at BT (the funds management arm of Westpac) handled the tough market conditions.Wright says these seasoned professional investors were unshaken in their belief that their investment processes would hold them in relatively good stead.Asked to name the Australian share funds managers that he regards highly, Paul Pavlidis of Lonsec nominates Ausbil Dexia, Arnhem, Fidelity and Schroders as among the most outstanding.Morningstar's "gold" rated share funds include: Schroders Australian Equity Fund, Fidelity Australian Equities Fund,Greencape Broadcap Fund and Greencape High Conviction Fund. Eleven share funds are "silver" rated (see table).Alarm bellsKnowing when to dump a dud fund is equally as important as identifying a successful one. That means investors have to stay attuned to the telltale signs that a fund manager might no longer be doing a good job.By and large, investment researchers are more interested in talking about the good performers than the bad ones and most of their research is not available for free to the public anyway.So what should you look for?The most obvious cause for concern is continuing poor, risk-adjusted returns. "Risk-adjusted" means the returns produced for a given amount of risk.For instance, funds investing in shares listed on emerging markets are expected to produce very volatile returns. But investors can expect higher returns over the long term than could ordinarily be achieved by funds investing in less-risky markets.The next most likely warning sign is when key people leave the manager.This can follow mergers. The best publicly available information on changes at fund managers and ratings can be found at morningstar.com.au. The decision to sell should always be taken with care.Managed funds are long-term investments and periods of poor performance might only be temporary.Investors should also consider the impact that selling a fund will have on their overall investment strategy, Phillip Gray, the communications manager at Morningstar says.And be careful of any exit fees, Gray says. Many types of older funds have exit fees that can be 4 per cent or more of the balance in the fund.When to sell?With sharemarkets being hammered in recent years, it is likely many investors in managed funds are sitting on significant capital losses rather than gains.As the end of the financial year is approaching, investors might want to consider whether they should be selling out of their underperforming managed funds before June 30.The tax partner with Sydney accountants and advisers HLB Mann Judd, Peter Bembrick, says capital losses can be offset against capital gains.If the investor has capital gains on other investments this year, the investor could consider selling the managed fund and using the losses to offset against the capital gains.Tax on gains has to be paid in the year in which they are realised but losses can be carried forward indefinitely and used to offset future gains.Bembrick says investors want to avoid realising a gain this financial year and a loss next year.
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