How to tell if a fund or ETF will likely underperform

Morningstar has conducted research on active and passive investment strategies and their associated vehicles since 1986. Strategies are given a rating – Gold, Silver, Bronze, Neutral or Negative. These ratings are a summary expression of our analysts’ forward-looking analysis of the investment strategies. The top three ratings of Gold, Silver, and Bronze all indicate that our analysts expect the rated investment vehicle to beat the Morningstar Category index or category median over the long term.

Neutral and Negative ratings are given to strategies that are not expected to outperform.

Negative ratings

If our analysts assign a fund a Negative rating, there is an expectation that they will underperform over the long-term. These expectations have largely played out.
Taking the five-year period ended September 2022, we find the average excess return for strategies with Morningstar Analyst Ratings of Gold to be 0.23%. Negative-rated strategies, on the other hand, have shown excess returns of -0.44%.

There are characteristics that are common across these funds that have caused them to underperform.

What can we learn from a Negative rating?

Understanding the commonalities in funds that have been rated negative means that you’re able to integrate this into your fund and ETF selection process.
Steven Le, Manager Research Analyst, went in depth into what can detract from a good strategy in an Investing Compass episode. You’re able to listen below.

Or listen on Apple Podcasts, Spotify or YouTube.

Here are a few of the common characteristics of these funds and ETFs.

People

It is important to understand who you are entrusting with your savings. The overall quality of an investment team is a significant key to the ability to deliver superior performance relative to its benchmark and/or peers.

Evaluating an investment team requires that analysts assess, among other things, the individuals who make the key decisions on the portfolio; if there is more than one person in charge, how conflicts are resolved; resources that directly support the managers’ work on the strategy; the expertise and relevance of available resources supporting the strategy; and how incentive pay influences decision-making and team stability.

The relevant personnel are judged along several axes including experience and ability, key-person risk, and alignment of interests (meaning, do the people that run the fund invest their own money in the strategies).

With negatively rated strategies you will often find unstable teams that may have high turnover. You may also need to be wary of key person risk if one individual is crucial to the success of a particular strategy. This may be linked to another pillar – Process, where there is no strategy that is separate from the person that can continue on if they leave the firm.
Steven recommends joining AGM calls or meetings so you are able to ask questions about the structure and processes that the teams follow.

Process

Morningstar analysts are style-agnostic, meaning that, for equity strategies, there’s no preference of value over growth or momentum, or vice versa. For fixed-income strategies, both high-quality and credit-sensitive styles are viable. For multi-asset strategies, a wide range of approaches to asset allocation can succeed. This research pillar looks for strategies with a performance objective and investment process (for both security selection and portfolio construction) that is sensible, clearly defined, and repeatable.

It must also be implemented effectively. In addition, the portfolio should be constructed in a manner that is consistent with the investment process and performance objective.
The analysts look for strategies with a process distinctive enough to generate standout results in the future.

More specifically, for active funds or ETFs, understanding:

The investment philosophy that underpins the strategy;
The managers’ approach to risk management;
Our expectations for performance in different market environments assuming the process is adhered to;
Whether or not the process can add value across the cycle versus the relevant benchmark or category on a risk-adjusted basis;
The suitability of the strategy for different types of investors given the risks we would expect to see in its portfolio

For passive funds, I’ve written an article on how to choose between passive funds here.

The main point here that individual investors can assess is whether or not the process can add value. There are a few typical ways that funds don’t justify their fees. For example, closet indexing. The index represents the average return that an investor will receive. The whole reason an investor invests in active funds is because we want to do better than average – if an active fund looks too much like an index, then we are paying higher fees for a very small chance of getting a different outcome.

Fees can have significant impacts on returns and can reduce your investment outcomes significantly. For actively managed funds, the goal is generally to beat a benchmark or index. If you’re investing in a fund that is charging 1%, you’re already 1% behind the benchmark or index. You have to be confident in the manager’s ability to outperform by more than that figure – the higher the fee, the higher the hurdle.

Importantly, it is crucial to understand not just the value from a product standpoint, but also the value that it specifically provides for you. It is worth paying the fee for the strategy if it provides an investment that is suited to your particular investment goals – for example, tax minimisation, yield or capital preservation.

Parent

Morningstar believes it is important to evaluate the funds management company that offers the fund or ETF, regardless of whether the fund is active or passive. Other factors like the professionals running the fund and the process will have a more immediate impact, but they wouldn’t be sustainable without the backing from the funds management company. There are several important factors that should be considered, including capacity management, risk management, and more importantly any firmwide policies that may drive or impede the alignment of the firms’ interests with those of the investors in the fund.

Beyond these operational areas, the analysts prefer firms that have a culture of stewardship and put investors first to those that are too heavily weighted to salesmanship. The former tend to operate within their circle of competence, do a good job of aligning manager interests with those of investors in their funds, charge reasonable fees, communicate well with strategy investors, and treat investors' capital as if it were their own.

Firms oriented to putting their own interests first might be characterised by their view of investors as sales opportunities—they tend to offer faddish products in an attempt to gather assets and have higher charges and incentive programs that do a poor job of aligning managers’ interests with those of investors. For example, companies that release thematic ETF after thematic ETF as a marketing tool to bring in fund flows.

Again, Steven’s advice would be to attend annual meetings, go through the PDS or annual report that should offer a more balanced view than marketing material.

Final thoughts

Given the number of products available and the constraints that individual investors face when evaluating a fund or ETF it can be difficult to know where to start. We all want to find the best performing funds and ETFs but sometimes it is best to simply avoid making mistakes. Using our analyst’s approach to identifying poor performing funds and ETFs may be a good starting point for investors.