The iceberg of investment analysis: beyond returns and holdings

Morningstar's Ian Tam's insights on enhancing client-advisor relationships through KYP requirements

The iceberg of investment analysis: beyond returns and holdings

This article was produced in partnership with Morningstar.

Morningstar firmly believes that deep insights into investment funds provide a substantial opportunity to connect with clients and prospects, further cementing the value of advice.

Ian Tam Director of Investment Research at Morningstar highlighted a crucial limitation in fund analysis: the reliance on fund returns as the primary assessment tool. While easily accessible and straightforward, returns fail to paint the full picture, notably omitting key elements like risk, the nature, and structure of the investment. This oversight can misguide investors, especially when differentiating between actively and passively managed funds, or understanding a fund's behavior in varying market conditions.

Tam says, “Returns are often the go-to metric for advisors and investors alike, primarily because they are the most accessible and straightforward to comprehend. Returns data is widely published, easily obtainable from numerous sources, and simple to understand.

“However, returns don't provide a complete picture, especially in terms of the risk involved, or the specific nature and structure of the investment. Critical factors, such as whether the fund is actively or passively managed, the management style, and other characteristics significantly influence a fund's future performance.

“The common adage, ‘Past returns are not indicative of future results,’ holds true here.”

The importance of knowing your product (KYP)

Tam emphasizes the significance of the Know-Your-Product (KYP) requirement under client focus reforms. He shed light on the pressures faced by Canadian advisors, such as diminishing fees and the shift away from bundled mutual funds, which imposes the need to demonstrate their value more than ever. This situation leads advisors to rely heavily on technology and surface-level information, potentially overlooking the in-depth analysis crucial in understanding investment products fully.

The enhanced KYP requirements represent a significant shift in the financial advisory sector. This shift not only benefits the sophisticated investor seeking more in-depth discussions but also ensures that all clients receive diligent and informed advice, in line with the best stewardship practices.

The misleading nature of standard deviation in risk assessment

Discussing standard deviation as a basic risk metric, Tam points out its limitations. The metric, which is a default on fund fact sheets, treats upside and downside risks equally and often excludes significant past events like the financial crisis. This approach could lead to a skewed understanding of a fund's actual risk profile.

Secondly, standard deviation treats both upside and downside volatility equally. It considers a fund's performance, whether it's up 10% or down 10%, as a measure of risk. While this is technically accurate, it doesn't align with investor sentiment. Most investors are less concerned about upside risk, or the fund performing exceptionally well. They are more focused on the potential for loss, or downside risk. Treating both types of volatility equally can obscure a true understanding of the fund's risk profile.

At Morningstar, the risk assessment approach, especially in their star rating system, incorporates utility theory. This theory posits that investors prefer more consistent returns over high volatility and are more concerned about downside risks. This preference is integrated into Morningstar's star rating methodology, offering a more nuanced understanding of risk that emphasizes the impact of negative performance over positive swings. This approach aligns more closely with typical investor concerns, providing a more accurate and useful risk assessment.

Sustainable investing: beyond financial metrics

Tam urges investors to first identify their sustainable investing goals, whether it's financial returns, reducing risks, or contributing positively to the planet. Morningstar's framework helps in this regard, suggesting approaches like negative screenings, ESG integration, and positive screenings to align with various investor goals.

Tam says, “For investors, it's essential to first clarify why sustainable investing appeals to them. Is it to improve portfolio performance, or is there a desire to contribute positively to future generations? This understanding helps in selecting the appropriate strategy.

“For example, in negative screening, it's crucial to examine a fund's portfolio holdings beyond their direct involvement, considering indirect revenue sources as well. A retail chain that sells tobacco products, though not primarily a tobacco company, still derives significant revenue from tobacco sales, which might be a consideration for sustainable investors. Such detailed insights, which go beyond simple return metrics, can be obtained through research and analysis, often with the help of firms like Morningstar.”Top of Form

The role of technology in future fund analysis

Tam acknowledges the growing role of technology in fund analysis, cautioning against over-reliance on it. Advisors need to ensure the quality and source of information they use while embracing technological advancements, striking a balance between efficiency and thorough, well-informed decision-making.

Recognizing that not all advisors may have the time or resources to conduct in-depth research, Morningstar's forward-looking analyst ratings provide a qualitative perspective that incorporates crucial information about a fund's potential future performance.

As a longstanding member of the Canadian financial community, Morningstar's involvement goes beyond being a data and research provider. Their engagement with industry associations and global sustainable investing committees further solidifies their commitment to empowering investor success in Canada.

Morningstar's white paper offers further details, providing a comprehensive look at the intricacies of investment fund analysis.