Need to look at fees while assessing alpha, says funds specialist

Germaine Share is director of manager research for Asia at Morningstar Asia, a wholly owned subsidiary or US-headquartered Morningstar Inc.

Share leads the manager research team in Hong Kong, Singapore, and China in producing qualitative ratings and insightful research for investors. She also oversees the delivery of manager research services in the region.

Her research team assesses funds not just for performance but also considers others factors such as company culture and fees.

"Fees will always weigh on an investors experience because it takes away some of your returns,” Share told AsianInvestor in an interview.

"So, our methodology also involves, as a last step, a subtraction of the fee from the fund’s estimated alpha. The higher the fees, the tougher it will be to get a good [Morningstar] rating.”

Share also discusses Morningstar's updated methodology, some red flags and some good practices in the funds industry.

This interview has been lightly edited for clarity and brevity.

How many members are there in your team?

There are 8 of us in Hong Kong, and Singapore. Globally we have just over 110 analysts. In Asia, we act as consultants and advise on fund selection.

Could you give an example of a Morningstar fund research client?

One notable client of ours is Singapore’s Central Provident Fund, where our responsibility can be broadly divided into two parts.

One part is when an asset manager decides to on-board a fund on the CPF platform, we perform an independent evaluation on the fund.

The second part is the ongoing monitoring of the funds. A fund that was already approved on the platform may have experienced a significant change like a portfolio manager departure, and we would re-evaluate the ongoing merits of the fund.

What is the focus of Morningstar’s funds research in Asia?

Our main research output is the Morningstar Medalist Ratings.

It’s a five-tier scale. I like to compare it to the Olympics, where our positive ratings are the Gold, Silver, and Bronze ratings.

These are the funds that we have confidence will outperform the market over a full market cycle.

Then we have Neutral ratings – which are funds that we expect will perform similar to the market.

Finally, we have Negative ratings, which are those that we believe will underperform over a full market cycle.

We arrive at these ratings after rigorous research – we speak to the fund manager to assess their experience and expertise, the investment process, and the fund’s performance.

Morningstar undertook a methodology enhancement in late 2019. What were some of the key changes?

One big change was incorporating the consideration for the alpha potential of the asset class.

For example, if you look at US large cap growth funds – this is not an asset class where active funds have had much success.

The market offers a wide range of cheap ETFs for such exposure. In these categories, it would be much harder for an active fund to beat the benchmark, and therefore much harder to win our Gold, Silver, or Bronze ratings.

On the other end of the spectrum, you have China A shares, which is a developing market, with a lot of new companies coming online.

For the most part, it is still under researched from a global context and has more alpha potential to exploit.

In this asset class, all other things being equal, it is easier to earn a Gold, Silver, or Bronze medal.

Once we determine the alpha potential of the asset class, our analysts will embark on a ‘three pillar’ methodology.

This involves a qualitative assessment of a fund’s people, process, and parent. Does the manager have the relevant expertise?

Are they supported by large and stable analyst teams to help them identify investment opportunities? On the process side, how does the portfolio manager put together the portfolio and manage risk?

When assessing an investment process, we don’t have a style preference – we are style agnostic. What we would like to see is whether the investment process is well structured and repeatable.

So, one question I like to ask in our internal committees is, if the portfolio manager gets hit by a bus tomorrow, could someone on the team readily step up and use the same structured process to replicate the results?

Finally, we also consider the parent company because it sets the tone for investment culture, talent retention, product launches, and fee policies.

Another key change in our methodology was to place a bigger emphasis on fees.

Fees will always weigh on an investor's experience because it takes away some of your returns.

So, our methodology also involves, as a last step, a subtraction of the fee from the fund’s estimated alpha. So higher the fees, the tougher it will be to get a good rating.

What are some of the red flags when it comes to separating good funds from bad?

One of the red flags would include a high turnover level on the portfolio manager team.

When a portfolio manager changes, they might bring in a new investment process. And they need time and to build rapport and work with analyst teams.

Investors often select funds based on a fund’s past performance. However, that strong track record may have been built by the previous manager. A new manager may produce different results.

It is just like a company getting a new CEO -- it might bring about different outcomes.

Another red flag is when an active fund is very benchmark hugging.

Active funds aim to add value by making bets that deviate from the benchmark, while funds that look highly similar to the benchmark will likely have limited alpha potential.

Poor capacity management is also a red flag. This refers to funds getting so big (on AUM) that they are no longer able to implement a process that can generate good returns previously.

Take small-cap funds, for instance, which are naturally going to be more capacity constrained.

For a large fund to build a meaningful position in a small-cap company, it may inevitably own a large share or even most of the company.

So, capacity management is important here – we would like to see the asset management company making an active effort in limiting fund flows especially if they start to see that the large asset base is compromising how the fund is being managed.

Are there examples of any good practices by funds?

Some good practices we have seen are some funds would soft close their fund and not onboard new clients.

Some asset managers also implement quarterly quotas for their institutional clients – only a certain amount of money can flow into a strategy in a particular quarter for example. If the quota is full, investors must wait for the next quarter.