Patrick Cairns
5 minute read
17 Nov 2015
1:39 pm

What investors want

Patrick Cairns

Morningstar study shows clear preferences in fund selection.

Picture: Thinkstock

South African investors currently have a choice of 1 274 locally-registered unit trusts. That is a sizeable number on its own, but once you go outside of our borders, there are more than 74 000 funds from which to take your pick.

This is a huge global industry, and collective investments or mutual funds are often the primary tool that ordinary citizens use for saving and investing.

The obvious question that the size of the industry raises, however, is how do they choose? What will make someone pick one fund over another?

In a first-of-its kind study, investment research firm Morningstar has published a paper on the factors that drive investment flows. It identifies persistent patterns that it believes show how certain kinds of funds attract bigger inflows, suggesting that investors have clear preferences.

Past performance

It is not surprising that a key variable is past performance. The Morningstar study presents this as a response to its own Morningstar “star ratings”, but one suspects that there will be some debate around how much influence the company itself actually has.

The star ratings are, after all, based on historical performance. The five star funds, which are those which show the best category-relative performance receive, on average, the highest inflows, while the one star funds have the largest outflows.

It is an intuitive outcome and perhaps the least interesting of the reports findings, except that it does at least show one thing: whether due to Morningstar’s ratings or some other fund ranking system, investors are at least aware of which funds have delivered the best returns.

Low cost

A second major factor in fund selection, in the US at least, is fees. There is clear evidence that investors are demanding, and increasingly getting, lower cost products.

“A recent report by Morningstar indicates that the asset-weighted expense ratios across all US funds have declined to 0.64% in 2014 compared with 0.76% in 2009,” the study notes. “Coinciding with this fee decline, the report finds that flows into passive investments far outstrip their active counterparts. Even within US active funds, Morningstar found that the funds in the cheapest quintile received approximately 95% of the estimated net new flows during that past decade.”

This is an astonishing finding – that just 20% of the actively-managed funds in the US saw 95% of new investments into such funds, and their common attribute is that their fees are below average. It’s even more compelling when one considers that Morningstar found that US equity funds with a higher than average net expense ratio experienced negative flows over the same period.

The study did note that this demand for lower cost is far more pronounced in the US than it is anywhere else, but that should not be taken as cause for relief by fund managers elsewhere. The US is at the forefront of the world’s mutual fund market and trends that take hold there almost inevitably spread across the globe.

Indexing is more popular in equities

Morningstar notes that assets under management in index products have grown by 132% globally since 2008, while assets in active funds have only grown by 18%. This growth in index products has been off a much lower base and in dollar terms active funds still receive more, but the trend is clear.

What is particularly interesting, however, is that the study shows that while inflows into equity index products was positive both in and outside of the US, fixed income index products actually experienced net outflows.

“It makes sense that we observe this effect because indexing works best in efficient, liquid capital markets,” the report notes. “Unlike equities, fixed income is typically less liquid due to the over-the-counter trading systems, and it has been argued that this makes the asset class less suited to indexing.”

In balanced products, investors prefer funds of funds

One of the most interesting findings in the study is that in the US funds of funds received significantly higher inflows in the balanced fund category than their single-manager peers. While this has largely been driven by defined-contribution retirement plans, it nevertheless highlights the kind of diversification investors are looking for.

“Funds of funds have been a huge success because they have helped protect the average investor from market-timing and from creating undiversified portfolios,” the study notes. “The result has been better long-term returns.”

While the fund-of-funds model has been criticised in the past for having higher fees, increasingly this is no longer the case. Managers of these funds are able deliver significant advantages to investors as they can add more precise diversification, select the top managers in each asset class and often make use of indexing to bring down the overall costs.

Investors want to be socially responsible

The Morningstar study found that, globally, funds that self-identify as socially responsible received on average 0.4% more flows per month than those that don’t. This is a factor that fund managers simply can’t afford to ignore.

“Our general conclusion is straightforward – investors have broadly and nearly universally preferred funds with socially conscious agendas,” the study says. “In aggregate and on average, when faced with similar options, investors would rather invest with funds that consider the social and environmental consequences of their investments.”

Fund manager tenure matters

Amongst the other findings, the most notable was that Morningstar discovered that equity fund managers with longer than average tenure are rewarded with higher inflows. Investors clearly value having a manager with experience and a demonstrable record, and a change in fund manager can have a significant impact on flows.

“Investors strongly prefer long-tenured managers and visible continuity of fund management,” Morningstar notes. “Given these results, we anticipate that funds with strong practices of comanagement and internal promotion will be better insulated from the adverse effects of manager departures.”

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