CHICAGO -- Sometimes when a fund has a very good year, it can be a bad thing.
A surprisingly strong return usually prompts Fidelity Investments to contact a fund manager to find out what is going on, says Jeff Mitchell, the firm's head of research in global asset allocation.
"Often times," he says, "they think we are calling to give them more money," but sometimes Fidelity pulls money out instead.
"It may be that a manager took on excessive risk in order to get that return," Mitchell says. "We think it's very important that you hold to a covenant. If it changes, we want to know why."
Mitchell and two other experts on a panel at the Morningstar conference broke down strategies advisors can use to evaluate fund managers for good stewardship or troubling behaviors that could point to larger problems. Their strategies include:
- Seek invested managers. Managers who "eat their own cooking" by investing alongside their clients. "We found regularly that firms and funds that have managers who invest alongside their shareholders have better results," says Bridget B. Hughes, associate director of parent and stewardship for Morningstar's Manager Research division.
- Find low fees. Funds with low fees also tend to perform better. Morningstar research has consistently demonstrated this fact.
- Look for long tenure. Seek funds with low manager turnover. "We look to the stability of leadership over time," Mitchell says. "We spend a lot of time thinking about the mission of the firm, how that is aligned with shareholders."
- Review board members. Scrutinize the biographies of a fund's board of directors. Make sure that the experience and skills of board members are likely to help fund managers stay on track, says Susan Ferris Wyderko, president and CEO of the Mutual Fund Directors Forum, a nonprofit membership organization for investment company directors. "If you've got a bunch of funds that are heavily into alternative investments," she says, "then you are going to look for a board that has some expertise in that area."
- Read SAI forms. A relatively obscure SEC filing called the "statement of additional information," also known as the SAI, contains the names, ages and work histories of a fund's board of directors, Wyderko says. "Another data point you can find is how much ownership each fund director has in the fund," she says. This ownership represents the director's own money invested in the fund, Wyderko says, because fund directors are not given fund shares for their service as many corporate directors are.
- Consider compliance. After deciding that one of its fund's cultures shifted to a less-rigorous respect for compliance standards, Mitchell said, Fidelity dropped the fund to avoid reputational risk. "You don't get any credit for following" rules and the law, Hughes says. "It's a demerit if you don't."
- Avoid salesmen. "Some of the things we are trying to gauge is, 'Is this a firm focused on salesmanship and gathering assets and building an empire?'" Hughes asks, or is this is a fund focused on being a steward for investors' money.
- Review outperformance. At a minimum, when a fund posts unexpectedly high returns, it means it's time for advisors to have a second look at their operations. Call up the advisor, Mitchell suggests, and you will get a better understanding of what they are doing. "If [the high return] is a deviation from what we think they should be doing, it can lead to us taking money away," Mitchell says.
- Understand underperformance. "If you own a quality manager and it is underperforming, understand you own that manager for a reason," Mitchell says, and that there may be good reasons for a down period.
- Assess your comfort level. Do the necessary due diligence, Mitchell says, to "make sure the firm is set up in the way you are comfortable with."
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