Close Close

Portfolio > Mutual Funds

Why Some New Funds Soar and Others Flop: Morningstar

Your article was successfully shared with the contacts you provided.

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.

Managers Matter 

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.

Managers’ Credentials

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.

Lower Fees

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.

When buying shares of new funds, investors consider the manager, firm and category characteristics of the fund more important, according to the report. Over time, however, “fees will affect a new fund’s track record, which will later heavily influence investors’ decisions.”

Morningstar found that during the subsequent 36 months, the most expensive equity fund in could lose out on 3% of risk-adjusted return while fixed income funds would forfeit 0.57% on average. “Knowing fees could be used as a proxy for forward success,” according to the report.

Fund Launches During Times of Economic Stress

Though counterintuitive, Morningstar found that funds launched during periods of rising market volatility tended to outperform over the subsequent 36 months. The increase in performance was 0.93% for equity funds, 0.52% for asset allocation funds and just 0.19% for bond funds.

Morningstar Analyst Rating

Although this may appear to be self-serving, the Morningstar report noted that coverage of newly launched funds by a Morningstar analyst, resulting in an analyst rating, has a history of boosting funds’ risk-adjusted returns and inflow.

Asset allocation funds are the primary beneficiary of this coverage, with returns gain as much as 4.7% while equity funds get a maximum 1.7% performance boost. The sooner the coverage, the greater the impact, according to the report.

Surprising Findings

Performance vs. Flows

Throughout much of the Morningstar report, the factors that led to higher risk-adjusted returns for funds usually also led to increased asset flows into those funds, but there were a few glaring exceptions.

For example, Morningstar found that asset flows tilted toward overvalued stocks over undervalued; large-cap over small-cap, more liquid over less liquid and less volatile over more volatile when the opposite characteristics offer potentially higher returns.

“Asset managers, to the extent they know about these investor preferences, are in a real pickle,” according to the report. “Do they choose to take style tilts that may be less sexy to investors now but ultimately result in better performance, or do they tilt in certain style directions that may be more palatable to investors now at the expense of lower expected returns?”

In other words, should managers choose asset flows now over performance later when stronger performance is more likely to lead to larger inflows?

Confusing Data About Female Portfolio Managers

Another finding in the report showed that investors in equity and fixed income funds preferred funds managed by women, according to fund flow data, but those funds didn’t have higher risk-adjusted returns. Asset allocation funds managed by women had higher returns but smaller asset flows.

Given these mixed results, Morningstar plans to investigate further the relationship between gender and fund management later this year.

— Related on ThinkAdvisor: