Financial advisers should look way beyond the basics when selecting mutual funds for their clients, according to Laura Lutton, editorial director at Morningstar Inc.
Ms. Lutton, speaking last week at the Morningstar Inc. conference, identified three key areas that can help advisers improve their clients' portfolios.
“You want to choose funds with low expense ratios, funds that are good corporate stewards, and you want to know what you own in the funds,” she said.
On the expense ratio issue, Ms. Lutton pointed out: “Cheaper funds are far more likely to outperform.”
Managers of more expensive funds often will take greater risks in order to overcome the higher expenses, she said.
“It doesn't matter if it's an A share, a retail fund or an institutional fund — you want to go cheaper,” Ms. Lutton said.
In terms of stewardship, which Morningstar has been evaluating since 2004, the emphasis is on five main criteria: corporate culture, fund board quality, fund manager compensation, fees and regulatory history.
Among other conclusions, Ms. Lutton said the overall stewardship grade can say a lot about a fund's long-term potential.
Between December 2004 and December 2010, only 7% of the funds that earned the highest A grade for stewardship were liquidated or merged. Among funds that earned a B grade, 8% did not survive the period. The percentage of funds not surviving the period increased as grades declined. Nineteen percent of the C-graded funds did not survive, nor did 25% of the D-graded funds and 33% of the F-graded funds.
Another telling indicator in the stewardship category is personal investment by portfolio managers. “Most managers own nothing in their own funds,” Ms. Lutton said. Only 42% of all stock and bond fund managers have at least $1 invested in the fund they manage. Of that 42%, about 60% are equity fund managers.
In 2005, the Securities and Exchange Commission required portfolio managers to disclose their ownership in the funds they manage. They are not required to invest in their own funds.
According to Ms. Lutton, the managers who invest the most in their funds oversee funds with an average star rating of 3.5 and have an average tenure of 12 years at the fund.
By contrast, those managers with no money invested in their fund oversee funds with an average star rating of 2.9 and have an average tenure of 4.6 years.
Ms. Lutton laid out her case for digging deeper into each fund by pointing out that investors, when left to their own devices, can make horrible investment decisions.
Using real estate mutual funds as an example, she said between 1999 and 2008, the category had a total return of 90%.
However, based on fund flow analysis, she concluded that investors in real estate funds lost roughly $5 billion over that period.
“We know that most investors move in and out at the wrong time,” she said.
E-mail Jeff Benjamin at [email protected].
