John Rekanthaler, Vice President - Research, Morningstar, was in Mumbai recently for the Morningstar Awards 2012.
At the awards ceremony, Rekanthaler, who is a CFA who joined Morningstar in 1988 and is a renowned name in fund analysis globally, gave a presentation titled "Reflections on Fund Management: Five Lessons from 25 Years", which went back over the evolution of the mutual-fund industry in the United States and drew key lessons fund companies should keep in mind to succeed in the long term.
Here is a summary of the presentation.
Leadership is not permanent
The list of top-12 fund companies in the United States back in 1986 looked radically different from the one of 2011, with several firms such as Merrill Lynch, Dean Witter, Kemper, Pru-Bache, EF Hutton, Shearson and IDS dropping out to give way to the likes of Vanguard, PIMCO and T Rowe Price among others.
The common asset managers that featured in both lists include Fidelity, Franklin Templeton, Federated and Dreyfus, some of which reinvented their approach along the way or are surviving on money-market assets.
Predictions often miss the mark
As humans, we tend to make mistakes and we should remember our past debates and be humble about making future predictions about the course fund companies think the industry will take in the future, he said. "Some of the smartest people in the industry focused on several wrong things."
He pointed out that some predictions made during the 80s--that banks would join hands with brokerages and dominate the fund industry as they controlled distribution or that no-load funds would win over front-load funds--did not turn out true.
Even back then, there were two different schools of thoughts which made the case either for active management or index investing as the way to go. Over the years, fund shops that focused on index investing such as Vanguard and I-Shares did well but active managers such as Fidelity and PIMCO proved there's a place for active management, too.
Change is not random
When the industry or its leaders change, there are always distinct patterns that emerge to have driven the transformation. Rekanthaler said he saw general traits in winning fund companies that have survived over the decades.
These included having an open architecture without hidden costs, having lower costs, creating products with a merit-based investment strategy, having a long-term focus and making funds that investors would buy rather than those need to pushed, while the losing companies displayed a closed architecture, had higher costs, tended to launch 'hot-concept' funds with regularity, had a focus on short-term sales, and their funds "needed to be sold".
"The winning companies usually focused on 'stewardship' instead of 'salesmanship'," he added.
Investor experience is paramount
"Asset managers often focus on the wrong things," Rekanthaler said, pointing out that firms that focus on near-term investment performance with an eye on short-term fund-category rankings or on finding hot funds and asset classes should instead look towards achieving long-term investor experience, retaining clients and curbing investor instincts.
He elaborated on the point by bringing up the concept of total returns versus investor returns.
A fund's total return is a point-to-point, time-weighted calculation of the absolute return a fund has made where the assumption is the investor bought and held for the entire period with no additional investments. While in investor return--a concept introduced by Morningstar--we make a money-weighted calculation, which accounts for aggregate monthly purchases and sales all of a fund's investors.
So consider Fund A that performed well when it was small in size (and thus making money for only a handful number of investors). After logging a solid performance, the fund sees a lot of inflows but witnesses a major drop the next year. Due to its bigger size, the fund has now lost a lot of money for its investors.
A fund whose performance swings wildly due either to an unstable investment strategy or because it tries to capitalize on flavour-of-the-season or 'hot' areas of the market would have poor investor return even if the overall total return looks decent.
"We have seen over time that fund companies that lasted were ones whose products fared well on the investor-return front as investors that have had a bad experience with a fund company's product tend to remember," Rekanthaler noted.
"We are in the investor modification business"
Rekanthaler urged fund companies to look to modify the behaviour of their investors for the better. "Investors are often wired to buy high and sell low," he said, noting that fund ads too often promoted "what investors wish they had bought before".
"Sometimes, fund managers take risks they wouldn't with their own money, the industry sells products its own employees wouldn't buy."
Advisors, too, were prone to the fear-and-greed cycle and fund companies should help their investors focus on the long term, he said.
In the United States, fund managers need to disclose the amount of money managers have invested in their own funds. "Funds of managers who invested a lot of their own money generally fared better than funds where managers had little or none of their own capital at stake," he noted.
Citing examples of good stewardship, he said managers of good funds sometimes closed entry into funds when they thought it was getting too big or to curb inflow of short-term money.
"Ultimately, it's a fundamental moral choice: do you amplify or moderate the greed-and-fear cycle? In the long run, the amplifiers lose even as they can make lots of money in the short term," Rekanthaler concluded. "Collectively, we need to alter our behaviour. In time, if the investor does not win, we all lose."