The vital factors in selecting an active fund

An expert from Morningstar gives some tips on what to look at in selecting an active fund

The vital factors in selecting an active fund
In any investment endeavour, due diligence is necessary. Investors dream of getting one hot tip or one reliable litmus test to determine the best pick from a pack of investments, but the reality is that more factors should be taken into account. That goes not just for individual stocks, but for active funds as well.

So what factors should investors look at when picking an active fund? One expert from global investment research firm Morningstar has some suggestions.

“As most readers know, we have rated funds for a number of years, attempting to separate winners from losers in advance,” said Jeffrey Ptak, CFA and head of global manager research with Morningstar. He explained that the firm follows five pillars:
  • Parent: Is the fund run by an investor-centric organization or a business protecting its own interests?
  • Process: Is the investment strategy prudent and robust even after it succeeds and assets flood in?
  • People: Does the portfolio management team have the right depth, talent, and level of commitment?
  • Price: Is the fund’s expense ratio low enough for managers to add value?
  • Performance: Does it affirm the stated investment process?

Ptak said that the five pillars above are affected by a number of other factors. While he didn’t want to identify just one top variable to consider in fund selection, he did provide a short list of the ones he would consider most strongly:
  • Expense Ratio: Morningstar’s research has found that expenses are more predictive of fund performance than just about every other variable because they chip away at returns. Ptak offered a second, often-overlooked reason: high expenses indicate a fund company’s desire for instant gratification, while lower expenses reflect a willingness to play the long game. He suggested looking at the expense ratio in a fund’s annual report.
  • Number of Funds Offered: “What you're trying to assess is how a firm defines its circle of competence, as evidenced by the types of products it has, and has not, made available,” Ptak said. He also recommended looking at the number of funds that were launched or mothballed in the past: watch out for managers that tend to make bets on hot sectors, only to fold once the trend fizzles out. This can be seen through fund inception and fund obsolete dates.
  • Portfolio Turnover: “The turnover ratio is the percentage of a portfolio that's bought or sold in a given year,” he said. While Morningstar recommends both high- and low-turnover equity managers, Ptak tends toward those with low turnover because to him, it indicates “well-founded inaction” brought by a long-term focus. This is reflected in the portfolio annual turnover rate.
  • Manager Investment: This simply indicates how willing a manager is to put his money where his mouth is. By investing in the fund he runs, he aligns his own interests with those of the fund’s other investors. The amount of skin the manager has in the game can be seen via the manager ownership level.
  • Manager Tenure: This factor on its own isn’t very revealing, according to Ptak. But it can be useful in revealing the qualities of a fund firm and explaining the performance of a fund. Some investors would want to know how willing a firm is to hold on to its investment professionals long-term, even in times of underperformance, as that could reflect the company culture. Seeing who’s had a hand in running a successful fund could also corroborate conclusions one might draw in other areas. Manager start dates and average manager tenure would be useful to look at for this factor.

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