These days, it seems that everyone has a "10-minute test" for picking stocks, including Morningstar's own Pat Dorsey in his Five Rules for Successful Stock Investing. Because there are now more than thousands of OEICs and Unit Trusts available for sale in the UK, the ability to figure out quickly which ones are worth detailed examination is as crucial in the fund realm as it is in the stock realm. Let's go through our own checklist for funds to help you narrow your focus.
A caveat before we start: Many of the rules I list have exceptions. However, if you apply these shortcuts, you'll significantly increase your chances of eliminating the duds.
Examine What the Fund Owns
You should have an idea of what you want your asset allocation to be--how much money you want in stocks and bonds--before you start looking at funds. If you're looking at a stock fund, ask whether it owns lots of big, recognisable companies, which can make it suitable as a core holding. Or is it a small-cap fund that owns businesses that you haven't heard of before, making it a good candidate for a supporting player in a portfolio? Is the manager impressed with earnings growth, or is he or she more value oriented, trying to buy stable earnings or assets at a deeply discounted price? If it's a bond fund, does it hold longer-term bonds whose prices may bounce around as interest rates move, or is a shorter-term fund that will remain steadier but typically pay you less interest? Use the Morningstar Style Box for stock and bond funds to understand what a particular fund does.
Avoid High Expenses
Funds are one of the few areas of life where paying more rarely gets you a better product. Fees cut into performance in a big way over the long term. For example, say you invested £4,000 a year for 30 years in each of two funds, one charging a 1% TER (Total Expense Ratio) each year and the other charging 2%. Assuming you earned an identical pre-expense return of 9% in both funds, at the end of the period you'd have accumulated £453,000 in the cheap fund and just £378,000 in the more expensive one. The lesson: Choose the lower cost alternative whenever possible. A fund’s ability to outperform can ebb and flow over time, but high fees will eat away at your nest egg year after year.
Look for Experienced Management
Another factor to consider is manager tenure. A manager who's been through a bear market or, better still, a couple of the market's routine ups and downs is more likely to stick to his or her style when the going gets tough instead of trying to time what's hot. We think sticking to a style is a strong prerequisite for long-term success in money management. Look for at least five years of experience. If a manager hasn't been running a fund that long, try to see if he's managed other funds successfully.
Avoid the Fast Traders
Although there are a handful of managers who have earned their keep by using fast-trading strategies, you can live a long and happy life without having such a fund in your portfolio. That's because quick trading doesn't exhibit the business approach to investing that we favor, whereby one tries to purchase a piece of the future profits of a business at a cheap or reasonable price. Moreover, the commissions for all those trades cost shareholders money and aren't reflected in the expense ratio. If you're looking to winnow down the fund universe to a more manageable group, look for turnover ratios of 50% or less on stock funds, which implies that the fund is holding a stock for two years, on average.
Look for a Manager with Skin in the Game
One of the questions we always ask managers is whether or not they invest substantial sums in their own funds. If they do, it shows they believe in their strategy enough to risk their own capital. It also helps align their interests more closely with those of the investors in their funds. For the same reason, we also check how they’re paid—it’s not the amount we care about, it’s the structure of incentive compensation. A manager who is paid based on 12 month returns, for example, may be more inclined to take large near –term risks in an effort to merit a big bonus, while one who is paid based on three to five-year returns may well focus more on longer-term results. This information can be difficult to come by in the UK (in other countries, disclosure is required), but we’ll discuss the topics in our forthcoming qualitative fund analyses.
Look at Long-Term Performance
Performance is usually the first thing that captures investors' attention, but it makes them forget about all the other important things that often result in or are the precursors to good performance. Moreover, investors often imbue short-term performance with too much meaning. Our advice regarding judging a fund's performance is that longer time periods provide the most insight into how a fund is apt to behave in the future. Five years should be the minimum, and 10 years is preferable. Keep in mind the dates of manager changes so that you attribute the correct performance to the manager who is running the fund now. The Morningstar Rating for funds is based on longer-term performance (when a fund has it), adjusted for volatility.
Evaluate Risk Concentrations
You can quickly check a fund’s risk by looking at its standard deviation over a given period of time. We display the three-year standard deviation of returns on the “Risk and Ratings” tab of every fund’s QuickTake report on Morningstar.co.uk. The Morningstar Risk portion of the ratings page also shows you how the fund stacks up against other offerings in its Morningstar category using our proprietary risk measure (you can read the methodology here). Do take care, however—a fund may have below-average Morningstar risk for its category, but still have high risk relative to the fund universe as a whole.
As we’ve argued in the past, however, these returns-based assessments of risk can miss crucial hints of risks to come. So be sure to take a moment to check things such as a fund’s regional and country exposures, asset allocation, its concentration in individual sectors and issues, its concentration in market-cap ranges, and how much valuation risk it’s taking on. Click here for more information on assessing these factors.
Beyond the Checklist
We’ll soon begin publishing qualitative analyses of funds on Morningstar.co.uk. My fellow fund analysts and I try to be sensitive to a particular fund's quirks, indicating when you should overlook things like fees (rarely) or recent performance (less rarely). Our analyses will be sensitive to what could go wrong with a fund--or at least what could put it in a slump--and will conclude as firmly as possible whether we think a fund is good at what it does.
