Simply by identifying funds in which the fund managers themselves invest heavily can improve your odds to 50-50 of finding a fund that will out-perform a benchmark or its peers, David O’Leary, the director of manager research at Morningstar South Africa, says.
Considering that, on average, 75 percent of active fund managers consistently under-perform, it is in your interests to improve your odds of finding a manager that can out-perform to at least a “coin-toss”.
There is a lot of good evidence to support a correlation between performance and significant co-investment by the people who run funds, O’Leary says.
“What more incentive do managers need to provide performance than to be invested in the funds themselves?” he says.
Co-investment is important, because the higher the co-investment, the more likely the interests of the asset manager and your interests will be aligned, he says.
Morningstar rates asset managers on a continuum, from stewardship to salesmanship. A steward would be completely focused on looking after the interests of investors, whereas a salesman would be concerned only with maximising profits and satisfying shareholders, O’Leary says. No asset manager will fall entirely at either extreme of this continuum.
It would be unrealistic to expect a manager to be a steward only; after all, asset managers are in business to make a profit. What Morningstar wants to establish is how successful a manager is at striking a balance between the competing demands of being in business and looking after its clients, or, to put it negatively, the extent to which a manager is prepared to sacrifice investors’ interests on the altar of profitability and growth.
O’Leary says Morningstar’s research shows that there is a very strong link between stewardship and performance. In other words, it is in your interests for your financial adviser, when selecting investments on your behalf, to look for asset managers whose practices are characteristic of stewards.
When ranking asset managers on the stewardship-salesmanship continuum, Morningstar looks at four aspects, or pillars, of a company: corporate culture, financial incentives (including co-investment), fees and regulatory history.
O’Leary cautions that these pillars should not be seen in isolation from each other; rather, they are designed to capture different aspects of what makes an asset manager “tick”. Taken together, they reveal certain patterns and trends that indicate on which side of the spectrum an asset manager falls.
He says you should also not make the mistake of believing there is a simple correlation between high levels of stewardship and high returns; just because a company is a good steward does not mean that all of its funds will always out-perform. However, identifying stewards does significantly improve your odds of finding managers whose funds will out-perform.
Pillar I: Corporate culture
Corporate culture can be thought of as an asset manager’s DNA. Understanding a firm’s corporate culture will tell you why a firm exists, what motivates its staff, and what distinguishes it from its peers, O’Leary says. Morningstar bases its view of an asset manager’s corporate culture on looking at its product shelf (the investments it offers), communication and employee turnover.
Morningstar looks at how many funds are on offer, the firm’s rationale for offering the funds it does, and whether the overall offering reflects a coherent and thoughtful investment philosophy. Morningstar also looks at the manager’s attitude towards capacity constraints – is it willing to cap funds and turn away new business in order to protect the interests of existing investors? It also analyses when a manager opens and closes funds – does the manager launch new funds simply to coincide with market peaks or to join the latest investment trend, and then suddenly close funds when they perform badly? The latter behaviour is characteristic of a salesman, whereas a steward, concerned about investors’ interests over the long term, would not be known for launching and closing funds.
O’Leary says a firm with a large number of funds is not automatically a salesman rather than a steward. However, Morningstar’s research in North America indicates that firms with six to 10 funds have, on average, a better chance of out-performing over three, five and 10 years than those with 11 funds or more.
Communication includes the information on a company’s website, its letters to investors, articles in trade publications, fund fact sheets and advertisements, O’Leary says.
He says the communication of an asset manager that is a steward will have the following characteristics:
* The level of communication will exceed the minimum required by regulations;
* The content will be organised and coherent;
* Investors’ key questions will be answered; and
* It will not be misleading – you will be told what you can realistically expect from the investment.
The hallmark of communications by a steward is disclosure that enables investors to be matched with funds that are appropriate for their needs and circumstances, O’Leary says.
Morningstar also establishes whether an asset management company can attract and retain talent. O’Leary says research suggests that, on average, the funds of asset managers with high employee turnover perform worse than those of managers who retain their staff.
Pillar II: Financial incentives
O’Leary says Morningstar looks at financial incentives from two angles: compensation and co-investment.
In South Africa, fund managers are compensated through a salary and bonuses. When assessing stewardship, the key question is the extent to which bonuses are directly linked to a manager generating investment out-performance over the long term. Managers may be rewarded for growing the business (for example, by increasing assets under management, overall profitability and product sales), but a business can grow without investors seeing any improvement in the performance of their investments, O’Leary says.
A high level of co-investment is perhaps the single most important way to identify a steward, says O’Leary. In fact, this can compensate for a number of characteristics that would otherwise count against an asset manager. The reason is that co-investment ensures there is a strong alignment between the interests of managers and the interests of investors.
Co-investment is far better than compensation in aligning the interests of managers and investors. The bonus system rewards a manager if the fund does well – but the manager still receives a generous salary if it does not. Co-investment means that the manager’s own money is on the line, so he or she will be concerned about the level of risk taken to achieve out-performance, not just the potential returns.
If, as Morningstar’s research shows, there is a clear link between co-investment and performance, you or your financial planner has every reason to ask for this information. “It could even be argued that planners have a fiduciary duty to ask for it.”
The challenge is how to obtain the information, O’Leary says. The United States is the only country where fund managers have to disclose whether they invest in the funds they run.
O’Leary says that when he speaks to fund managers about what they look for when considering investing their fund’s assets in a company, their response is often quality management and a management team that owns a share of the business. But, ironically, when O’Leary asks fund managers if they are invested in the funds they run, they say they aren’t prepared to divulge that sort of information.
There are valid concerns about privacy, and it would be unreasonable to expect fund managers to reveal their personal finances to the public, O’Leary says. But there are ways to accommodate these concerns. For example, a firm could disclose that all of its funds are run by managers who have at least twice their basic annual salaries invested in the funds they manage. This would not be ideal, but it would reveal whether under-performance poses a significant degree of risk to the fund managers.
O’Leary urged financial planners to find “flexible and creative ways” of obtaining information about co-investment.
Pillar III: Fees
It is “obvious” that high fees are bad for performance, and “mounds” of data show that, on average, the cheaper the fund, the better the performance, O’Leary says.
He says some investors believe that paying a performance fee (a fee on top of the annual fee for returns that exceed a certain benchmark) is a way of aligning their interests with those of the fund manager. The reasoning is that the better the manager does his or her job (higher returns, which benefit investors), the more he or she will be rewarded (higher performance fees).
O’Leary says performance fees are not a way of aligning your interests and the manager’s interests, and there are three related arguments against them: they are too complicated, they are risky and they are unnecessary.
* Complexity. It is nearly impossible to calculate performance fees, because the information required to work them out is rarely disclosed in full. Furthermore, it is difficult to understand the complex rules that govern the calculations. In other words, in most cases, you do not know how the fees will actually affect your returns.
* Risk. Performance fees can be thought of as a set of rules that have been created to elicit a certain type of behaviour from people who run funds: the better they do their jobs, the more they will be paid. The financial services industry is staffed by very intelligent people who like to figure out puzzles, O’Leary says. If you give them a set of rules, they will very quickly find the loopholes, although not every manager who finds the loopholes will exploit them. The more complicated the performance fee structure, the higher the risk that there will be loopholes that can be exploited. Therefore, your risk is two-fold: first, that the structure of the performance fees is such that they can’t “be gamed” and, second, that any loopholes won’t be exploited.
* Unnecessary. Performance fees cannot be justified, O’Leary says. Why, he asks, should portfolio managers be paid more to do the best job possible on your behalf – shouldn’t they do this anyway? Other professions do not have performance fees. Surgeons, for example, are not paid an additional fee if they carry out organ transplants successfully. It is expected that people will do the right thing as a matter of course.
He says that performance fees are asymmetrical: managers are paid a base fee no matter how the fund performs, and then they get a fee for upside performance. If managers are going to be paid performance fees, then they should have to share in the downside risk, too – although this is hardly ever the case.
Pillar IV: Regulatory history
You probably would not want to give your money to an asset manager that is bumping up against the law regularly, and therefore it would be useful to know how often a manager has had to be reminded by the regulators to get back into line, David O’Leary says. This information exists, but in South Africa the level of regulatory disclosure is very low.
A major regulatory failure will be reported in the media, O’Leary says, but the results of routine audits and “nudges” by regulators for managers to get back on-side do not usually become known. The only way this type of information will be disclosed as a matter of course is if financial planners start to ask for it, and he urged planners to create a “dialogue” around the issue, he says.