Beware of These Fund Red Flags

There are many things to consider when picking a great fund to invest in, but knowing what to avoid is just as important

Sarah Dowling 10 May, 2023 | 11:37AM
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Investors are always on the lookout for winners, but knowing how to keep the losers out of your portfolio should be just as important.  

High fees, the departure of a solid manager, or a focus on an overhyped asset class – these are some of the "red flags" that can erode returns, or may even indicate a fund is on the verge of shutting down. 

I sat down with Morningstar’s director of manager research Michael Malseed to identify some of the major warnings signs investors should watch out for – whether investing in a fund for the first time, or for an existing holding.

While this article focuses on investment red flags, we have a wealth of resources to help readers learn more about fund investing, follow the links below for more: 

Considering an Investment? Watch Out for These:

A useful starting point for investors deciding where to invest is the Morningstar "medalist" rating, which evaluates whether a fund will be able to produce excess returns after fees, in the future. (Our medalist rating has recently been overhauled – see here for more.)

Our tracking shows that on aggregate, medalist-rated (gold/silver/bronze) funds outperformed funds rated neutral or negative in multiple periods after receiving the rating.

Red Flag 1: No Clear Path to Profitability 

With relatively low barriers to entry, investors should ensure the fund they’re considering is going to be around for the long term.  

"Make sure it's on a steady footing in terms of their business, profitability and sustainability," Malseed says. 

That can be relatively easy to identify with established firms with lots of funds under management, but for early stage funds, Malseed says there should be a clear path to profitability. 

"Say if their fee is 1% per annum and they're managing £50 million as some funds will be, that's £500,000 a year of revenue that they might generate. That's not really much to pay the rent and to pay salaries, and to pay for Bloomberg terminals and whatever else you need to run a funds management business," he says. 

"But in those cases what we look for is for them to have some sort of financial backer that's underpinning or providing a backstop and providing working capital to them to pay salaries and to pay costs for a term of say five years. So you're at least underwritten for 5 years."

He says firms backed by boutique incubators, such as Bennalong or Pinnacle, will often start up as loss-making enterprises with a pathway to break-even. 

"But there are firms out there, that will start up with no backer, perhaps investing money from friends and family. I'd be more cautious with those, and I’d be asking more questions about what the pathway to profitability and sustainability is for those firms," he says.   

"You don't want to go to the trouble of investing your money in a fund on a three- to five-year view, and in two years it has to shut down, because I just didn't get traction."

Red Flag 2: The Portfolio Manager Has no Track Record

This isn’t uncommon at the small end of the market, Malseed says, given the relatively low barrier to entry to starting up a fund.

"You want to know that the portfolio manager has relevant experience in managing the funds that they’re offering, because it could be the case that they’ve got very little experience in the actual fund or strategy that they’re managing and could have come from another asset class or style," he says. 

"The way that the boutique incubators work is they will pull out a person or a team from an as an established fund manager, and then back them into starting their own business."

Red Flag 3: Fees

Fees are a key consideration in buying a fund because they are the single most consistent detracting factor from an investor’s returns. 

This is largely because fees are charged regardless of how the fund performs. 

Malseed says investors should consider whether a fee is appropriate and fair, but also the way fees are structured. 

"Something you'll see in the market is fee structures that aren’t appropriate, they don't have appropriate benchmarks," he says. 

"So an example of that is a strategy that will take on equity risk but have a cash benchmark, and then charge a performance fee for any out performance over cash. 

"Equities will outperform cash over the long term because they have more risk. If a fund is charging a performance fee on an equity return over cash it's a free kick for them."

As Morningstar director of manager research ratings Annika Bradley explores in depth here, fees have a number of components, and understanding their nuances is critical if you want to compare apples with apples.

Red Flag 4: A Fund Has Massively Outperformed 

When looking at a new funds, Malseed cautions against chasing investment performance. 

"If performance looks too good to be true you just need to dig into why that performance has occurred," he says.  

"If a strategy has massively outperformed the peer group one year, it's more likely due to taking greater risk then just manager skill."

Morningstar research shows investors often poorly time their fund purchases, by buying too late and getting swept up in a market correction.  

"For example, in the last five years with the growth stocks rally, you've seen funds with concentrated exposure to tech stocks doing very, very well. You could have chased that performance and then in this downturn that we've seen with the market during the last 18 months, those strategies have given back most of their return, if not more."

It's important to have a critical eye to performance and not just chase last year's winner. 

For a Fund You Already Own

For those already invested with an established fund manager who has so far ticked all the boxes, don't be complacent. Sometimes, big red flags can pop up that makes you reconsider your investment.

Red Flag 1: The Manager Quits

The departure of a key portfolio manager can hobble a formerly solid team. Thoughtful succession planning can minimise the blow, but it is always worthwhile to assess an altered team’s potential to deliver future outperformance for investors.

"Portfolio manager departure is a big one because an active fund manager is a people business," Malseed says. "So that's a major red flag that will trigger us to review an investment."

"If the portfolio manager leaves and there’s no clear successor then you don’t necessarily know what you what you're going to get."

One of the most high-profile examples of the poor management of 'key person risk' was the departure of Magellan co-founder Hamish Douglass, he says.

In December 2021, chief executive Brett Cairns abruptly resigned. In the same month, St James’s Place – Magellan’s then-largest investor and its anchor client – also withdrew its mandate. This was followed by co-founder Hamish Douglass' indefinite leave in February 2022, which led to his resignation from Magellan in June 2022.

"Magellan was a Gold rated fund manager with us. [Douglass’] departure was very unexpected and there hadn't been a clear successor in the firm all the way," he says.

"The way that was managed was it wasn't particularly smooth. So that led to us to review, and we downgraded our assessment of the strategy.

If a portfolio manager is going to retire, Malseed says that should be well flagged, with a transition process in place.

Red Flag 2: Underperformance and Outflows

Active funds are prone to spates of redemptions when they underperform peers or benchmarks. Throw in big losses, which were common in 2022’s rough markets, and investors become even more likely to cut bait.

A wave of net outflows can make it tough for managers to buy companies they consider cheap, particularly if they invest in less-liquid stocks.

"It becomes a concern if it puts the sustainability of the firm at risk, if it's a firm that has gone from being profitable to being unprofitable."

Malseed says it increases the risk of that firm shutting down, particularly if they lose a large institutional mandate.

It’s not unheard of. Bennalong-backed small cap investor Avoca Investment Management was wound up in 2020 after two institutional investors pulled their money.

"So that's a red flag, because you don't want to have to put your money somewhere else, you want to be invested for the long term."

Red Flag 3: Capacity Management

Malseed says it’s a red flag when businesses look to grow their funds under management for the sake of size.

"We’re focused on them growing FUM in a measured and responsible manner, that’s within their ability to manage without having detriment to impact on performance," he says.

"It's more likely to occur in, say, small cap investing because you've got much more constrained capacity than say in global equities large cap when you can manage tens of billions with no real concern about liquidity. But when you're investing in small companies there is a limit to size.

"So it's a red flag if a fund is getting too big, particularly if you see that performance drop off because they haven’t been able to trade as effectively as they had in the past."

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The information contained within is for educational and informational purposes ONLY. It is not intended nor should it be considered an invitation or inducement to buy or sell a security or securities noted within nor should it be viewed as a communication intended to persuade or incite you to buy or sell security or securities noted within. Any commentary provided is the opinion of the author and should not be considered a personalised recommendation. The information contained within should not be a person's sole basis for making an investment decision. Please contact your financial professional before making an investment decision.

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Sarah Dowling  Sarah Dowling is the editorial manager for Morningstar Australia

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