A surprising 73% of new investment flows are directed into mutual funds and ETFs that are less than 12 months old, according to Morningstar, which just released a study about why some of those funds succeed and others don’t.
Morningstar studied 57,000 mutual funds and ETFs in three categories – stocks, bonds and asset allocation – looking for what characteristics led to better risk-adjusted performance and larger inflows three years later, when those funds become eligible for star ratings.
Advisors investing clients’ money in new mutual funds or ETFs – and many apparently do – may want to consider those attributes beforehand if for no other reason than the fact that new funds don’t get Morningstar star ratings. Funds may however, receive a Morningstar analyst rating – either gold, silver, bronze, neutral or negative – before the three-year mark.
It’s not just the investment prowess of individual portfolio managers that can lead to better performance of one fund over another. Having an ownership stake in the fund as well as a CFA credential can also play important roles.
Managers’ Ownership of Fund Shares
Equity funds run by portfolio managers who own shares in the fund have a 5.5% higher risk-adjusted return than funds whose managers don’t have an ownership interest, according to the Morningstar report. For asset allocation and fixed income funds the boost to returns were 4% and 1.9%, respectively.
“Manager investment aligns incentives with those of investors and creates additional motivation for the manager to a good steward of capital,” according to the Morningstar report. ”This should result in better outcomes for investors.”
The report doesn’t compare performance based on the size of managers’ ownership stakes or purpose of those stakes – whether for marketing purposes or as an additional incentive for managers to perform.
Funds led by managers who are chartered financial analysts also have higher returns as well as larger investment flows, according to Morningstar.
The risk-adjusted returns of their funds are 1.1% to 1.5% higher than those of other funds.
Morningstar said it chose the CFA designation as the measure of manager education because of the easy availability of that data but noted that “any other designation that signals a higher education achievement to the investor would be rewarded in the same direction.”
Frequent Portfolio Disclosure
Funds that disclose portfolio holdings more frequently than required by law – more frequently than quarterly in the U.S. after their first year and more frequently than annually in many European countries – tend to have higher risk-adjusted returns as well as fund flows, according to Morningstar.
Equity funds that released their portfolio holdings during their first 12 months, which is not required by regulation or law, according to Morningstar quantitative analyst Madison Sargis, are expected to return 1.5% more over the following 36 months than funds that do not disclose their holdings. The additional returns for asset allocation funds and fixed income funds were 1.04% and 0.47%, respectively.
Beyond that first year, frequent disclosure of holdings is expected to add 0.3% to 0.4% increase in returns, according to Morningstar.
The reasons appear to be self-evident. ”With the lack of a track record, portfolio holdings can be a window into the fund’s process and help investors get a sense for the type of strategy the fund hopes to deploy,” the report notes.
The mantra that lower fees are key to fund performance is something that Morningstar, Vanguard and many consumer-oriented financial firms and analysts are constantly extolling but the report adds a somewhat surprising wrinkle to this long-held belief. “Fees are one of the most consistent drivers of flows and returns for new funds,” according to the Morningstar report. But they are only one factor among many – and not the most important one – when investors are deciding whether to invest in a new fund, according to Morningstar.