Picking winning funds: 3 steps to improve your odds

Picking winning funds is easy… after the fact. Identifying those winners in advance is a lot more difficult. Even professionals (myself included) often get it wrong. That’s because there are no sure things in the investment world. There are only odds. You can either improve your odds or worsen them, depending on the way in which you go about selecting investments. 

You can’t expect to hit a home-run every time you buy a fund. That’s why it’s important to remain diversified. Your goal should be to outperform in aggregate. At Morningstar we spend significant time researching funds in the hopes of discovering a few key insights to help nudge the odds slightly more in our favour. If that sounds depressing, keep in mind that even a small shift in odds can lead to huge changes in your long-term compound rate of return. 

But few people have the time or inclination to dedicate so much time to researching funds. Below are three pieces of advice that should help improve your odds of finding a winning fund; all without having to quit your day job. 

Stewardship 

Taking a long hard look at how well a firm treats its clients should be a big part of your decision to buy a particular unit trust. Since unit trusts are often meant as long term investments, you’ll want to partner with a firm that will treat you well long after you’ve signed the original purchase documents. 

Not only will you have a more pleasant experience investing with a firm that treats you well, but their funds are likely to perform better too. In the US, where we assign formal stewardship grades (A through F) to funds and fund companies, funds that receive higher stewardship grades tend to perform better. A study in 2009 by researchers at Cornell and Binghamton Universities found that US funds receiving an A or B stewardship grade performed 1.6 percentage points better annually relative to funds earning D’s and F’s. 

One way to think of evaluating stewardship is to imagine you’re conducting a character assessment. You can use any interaction you have with the firm – conversations with company reps, television interviews you’ve seen, public documents, the firm’s website, etc – to paint a picture of its character. 

Given this cumulative experience with a firm, ask yourself some of the following questions: 

• Does it feel like the firm is selling you a product or providing a professional service? In other words does it feel like you’re dealing with your doctor or a used car salesman? 

• Can you say what’s distinctive about the firm, its people, and its investment approach? If not, it probably doesn’t have a clear competitive advantage. 

• How expensive are its funds relative to other similar funds? Stay away from firms that gouge investors at every turn. 

• Has there been a lot of turnover in its personnel ranks? Firms that have a revolving door of employees coming and going are typically poorly run organisations. 

• How many funds does it offer? Is there a clear reason why each exists and can you tell them apart? The more funds a firm offers, the more difficult it is to manage and the harder it is to be an expert in all areas. 

• Are you able to get the information you want about the firm and its funds easily? If you still have many unanswered questions after your research it’s probably because the firm has chosen to be opaque or just doesn’t have its act together. Either way, it’s a bad sign. 

• Does the firm refer to its funds as “products” or “investments”? You’re not buying a new pair of shoes. You’re entrusting the firm with your hard earned savings. The language a firm uses can speak volumes about its attitude. 

Answers to these questions can tell you a lot about where the firm’s true interests lie. Of course, it would be unfair to judge a firm’s stewardship on any single issue. But cumulatively questions like this allow you to create a mosaic that shows whether a firm is focused more on salesmanship or stewardship. 

Financial incentives 

It’s also worth looking at whether a firm’s financial interests are aligned with yours. In my view, the best way to ensure this alignment of interests exists is to check whether the firm’s managers invest in their own funds. What more incentive could a company need to do well than having its own staff investing in the same funds they sell to the public? 

The table below demonstrates that the higher the co-investment by a fund’s manager, the longer the manager sticks around, and the better they perform. The data below is from the US; the only country in the world where fund managers must disclose their co-investment information. The far left column denotes a fund’s star rating – a measure of how well a fund has performed historically compared to other similar funds. The higher the star rating, the better the fund has performed.

There is no requirement for firms to disclose co-investment information in South Africa, but you can ask for it. Hopefully one day regulators will mandate this disclosure but until then we should all start demanding it. Knowing whether the person who is caring for your life savings actually has some skin in the game is important information. 

Past performance 

It’s common for investors to look at past performance when selecting funds. But instead of focusing on the level of a fund’s historical returns, investors should pay more attention to the variability of those returns. In other words, the journey is more important than the destination. The bumpier the ride, the more likely we are to make poor decisions. 

The field of behavioural finance has documented how volatility plays on emotions such as fear and greed, and how these often cloud our better judgment. In the world of finance, this typically means buying funds after huge spikes in performance (greed causes us to buy high) and selling when the fund starts suffering big losses (fear causes us to sell low). It’s also interesting to note that being aware of this phenomenon doesn’t immunise you from it. 

The following chart demonstrates how insidious volatility can be. This example from the US shows how a fund with a 10-year annualised return of 15% can deliver a terrible investor return. An investor return is a way of measuring a fund’s returns that places more weight on periods where a unit trust has more money invested in it and less weight on periods where fewer dollars are invested. After all, what good is a fund’s excellent return if no one is there to experience it?

In the example above, Fund A returns a whopping 34.9% in 1998 and 120% in 1999. However, the fund’s asset base is just $5.2 at the end of 1997 and $9.9 million at the end of 1998. Throughout 1999 money continues to pour in and by year end it reaches $72.4 million; just as the fund’s performance is peaking. The fund eventually reaches $118 million in AUM as performance starts dropping off a cliff and the fund experiences double digit losses from 2000 to 2002 while more people than ever before are invested in it. Investors then run for the hills after the fund suffers massive losses and most miss the fund’s rebound between 2003 and 2006. 

When you add it all up, the fund’s reported 15.1% annualised return translates into a 1.5% annualised loss for the average investor. 

Unfortunately there’s no hard rule for how much volatility is too much. The answer depends on each individual’s risk tolerance and circumstances. But be honest with yourself about how much you think you can handle and know that the more volatile your portfolio the more prone you’ll be to making poor decisions. 

David O’Leary is Director of Fund Research at Morningstar South Africa