Are you selecting the right funds for your clients?

Aug 09, 2016

The Indian mutual fund industry has grown manifold since private players were allowed to offer mutual fund schemes back in 1993. Now, with 44 asset management companies, or AMCs, offering more than 2,000 mutual fund schemes, leaves advisers with an ocean of mutual funds to select from.

Clients could hold multiple mutual funds, but do those funds fit well in their portfolios? Advisers are often faced with the dilemma as to how they can enhance their client’s overall experience and ensure that they recommend funds that meet their clients long term investing goals. While we emphasized on leaving asset allocation to an expert in the second section of this three-part series, the same principle applies to fund selection.

Selecting the right funds is a complex process that is based on looking at a combination of qualitative and quantitative factors. Letting an expert give you their inputs on funds lets you focus on building and nurturing client relationships, leaving out the complexities and freeing up your time associated with activities like asset allocation and fund manager selection.

With this in mind, we have designed the Morningstar Model Portfolios to give you access to the experience and expertise of the Morningstar group. Our model portfolio solutions can help advisers enhance investment offerings, strengthen client relationships and streamline business.

Morningstar offers risk profile based model portfolios ranging from cash plus till adventurous which are built for the long term, with a keen eye on risk and created to help meet your clients’ needs at each stage of their life. Constructing a model portfolio for clients involves a series of steps. Within each step, we apply various models and concepts that have been extensively researched and tested through practical implementation over a period of time.

Our first communication on Are your clients’ portfolios optimal?  and second communication on Leave asset allocation to the experts gave insight about Morningstar’s capital market assumptions, or CMAs, and asset allocation methodologies.

Empirical studies show that choosing actively managed mutual funds which best fit the optimal asset allocation is one of the key drivers of alpha generation. Blending asset classes and mutual funds together enables an investor to harness the benefits of diversification and improve the expected risk adjusted returns of their portfolios.

Common approach for selecting mutual funds

 A basic approach towards selecting mutual funds often depends on:

i) selecting flagship funds of few AMCs,

ii) selecting the most recent top quartile performers and

iii) selecting funds based on only quantitative parameters such as sharpe ratio, information ratio, etc.

This naïve approach towards selecting funds could lead to the investors holding a riskier portfolio with multiple overlaps in terms of the underlying stocks; one which may not perform in line with investor objectives over the long term.

There are several drawbacks of using these methods for selecting funds as part of an investor’s portfolio.

First, these methods don’t help in identifying AMCs that have a culture of stewardship and put investors first, to those that are too heavily weighted to salesmanship or look for funds with an investment process that is clearly defined.

Second, just looking solely at the recent performance of a fund ignores long term performance, overlooks how the fund is expected to perform across various market cycles and could lead to a performance chasing behavior.

Third, using only quantitative parameters based on historical numbers could lead to an incorrect reasoning in terms of being able to predict forward looking returns on a fund. Fourth, herd behavior leads to making investments in funds without considering client risk profile and portfolio suitability.

Morningstar’s way

Given that common methods of picking funds have their limitations, we try and overcome these by using a fund selection process that allocates capital to the most appropriate mutual funds to represent each specified asset class in a model portfolio. Morningstar believes that in-depth qualitative analysis that is tested and informed by quantitative analysis, lies at the heart of successful fund research.

The purpose of the qualitative selection methodology is to instill discipline into the fund selection process by appraising critical factors that can help determine a fund’s ability to meet its objectives. Funds are evaluated across the five pillars that Morningstar has identified as being helpful in predicting the future success of funds including Parent, People, Process, Performance and Price. The Morningstar Analyst RatingTM for funds is the summary expression of our forward-looking analysis of a fund.

We also acknowledge that qualitative analysis needs to be supported by quantitative analysis to either validate or question our understanding of a fund’s characteristics. The universe of Morningstar analyst rated funds forms the base for fund selection in our model portfolios to which we then apply quantitative checks.

The process of portfolio construction then begins with bringing together the asset allocation proposition and the mutual fund selection. We evaluate stock overlap and return correlation between funds, Style Box placement, and how funds’ sector exposures complement those of other funds within the overall model for which the fund is being selected. In simple terms, the idea is to choose funds that are clearly different from one another, rather than similar or redundant ones. The end result is a broadly diversified line-up containing carefully selected mutual funds we believe to be high-quality for each of the asset categories included in the model portfolios.

About Morningstar Model Portfolios

Morningstar Model Portfolios are based on more than 30 years of groundbreaking research on long-term strategic asset allocation. Our goal is to provide exposure to a broad range of asset classes that can be weighted according to our expectations of risk and reward.

In investing, the basics matter. That's why we begin with our own research showing that the mix of assets in a portfolio can have a greater impact on investment returns than timing markets. Guided by this research, we use risk and return forecasts across domestic asset classes and international equities to develop a strategic asset allocation for each portfolio. Independent and Institutional advisers can use these portfolios to help clients reach their financial goals.

We’re committed to helping independent and institutional advisers create better outcomes for their clients. You know your clients’ needs and how to build plans to meet them. We combine our investment knowledge with portfolio construction experience to provide investing solutions that put your clients first.


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