Why Good Mutual Fund Research Is Hard to Find
There are many brilliant books on stock picking, from simple beginners’ guides to classic textbooks like Ben Graham’s Security Analysis and The Intelligent Investor. I could find only one credible book on mutual funds: John Bogle’s Common Sense on Mutual Funds.
Bogle’s advice? Investors should put their money in index funds. A number of finance luminaries — Warren Buffett, Charles D. Ellis, and David Swensen, among them — also recommend sticking to index funds. If they are all correct, then there would seem to be little need for funds research.
The question is: Does their advice apply to all markets all the time? And if it doesn’t, why is there such a dearth of credible research on mutual funds? Are the experts’ recommendations more a function of the difficulty of picking funds rather than a fund’s inability to outperform?
Without wading into the active vs. passive debate, I want to examine why one firm dominates retail mutual fund research globally. By my count, there are at least three reasons why retail investors do not have access to more options:
- Selecting funds is easier said than done.
- The restricted access to information required for fund selection prevents a more vibrant funds research market from emerging.
- The research industry’s business model is difficult.
How Hard Is It to Pick Funds Anyway?
Running a funds research business is a huge commitment. There are more funds than stocks in some markets, with little overlap between retail and institutional funds. And with global capital flows, global capability is a necessity.
While some fund managers blame research houses and consultants for their own short-term mentality, the more thoughtful among them agree that it is difficult to choose among fund managers who all sound pretty good. The fact is, just as there isn’t one right way to pick stocks, there isn’t one right way to pick funds. One has to decide whether to use a quantitative or qualitative approach.
Most ratings available to retail investors rely on “hard facts” like track record — essentially permutations of past performance — and snapshots of portfolios to pick their relevant funds. Morningstar’s star ratings are an example.
The irony is when regulators insist on such “objective” analysis — but also require mutual funds to include a disclaimer on all communications reminding investors that “past performance is no guarantee of future results.” Even Morningstar seems to have admitted that its star ratings are not enough. Using a process similar to institutional consultants, Morningstar now also offers qualitative analyst ratings to complement their quantitative star ratings.
I believe the quantitative vs. qualitative debate is also related to expertise. While a qualitative process may make sense, it won’t work unless the researcher has the skills and knowledge to understand the nuances among the different fund managers she is analyzing. The problem is that funds research is not as glamorous or as well-paying as stock research. There are no star fund research analysts or fund analyst awards. So a research firm will struggle to attract talented and qualified individuals in the absence of a sustainable business model.
Access to information is not universal.
Unlike the case with stock selection, all relevant information necessary for funds selection is not publicly available. For example, while unit prices might be freely accessible, portfolio data is not. It is available to the most influential firms, like Morningstar, but not to smaller players or indeed to retail investors. Similarly, access to fund managers is restricted. Hence, larger research firms are able to maintain their monopoly.
The Poor Economics of Research
There are primarily four ways to make money in financial services:
- The product provider pays a fee directly or through advertisements or sponsorships.
- The client pays on transactions.
- The client pays a fee or for a subscription.
- The client pays ad valorem fees built into the product.
The most prevalent business model in research tends to be the product provider paying for the research directly or through ads and sponsorships. The popularity of this model is driven largely by the belief that clients — wealth managers and retail investors — will not pay for funds research. At a glance, this ought to reduce the independence of the analysis, but proponents of the model point to credit rating agencies and auditing firms that are paid by the firms under review and still maintain their independence.
Some larger research providers and consulting firms venture into multi-manager fund management — and face potential conflict of interest accusations. More importantly, this requires both a funds management license as well as distribution capability and thus, deeper pockets.
The choice of business model masks the real issue: Do research firms have a value proposition? For all their capabilities, many research providers do not publish their own track records. Probably for good reason.
I should point out that my previous employers did disclose their value add on a quarterly basis and were able to run a mostly client-pays business model. They also offered multi-manager funds. The small firm made a selection mistake and had to shut down, while the larger institutional consulting one, with better processes and deeper pockets, is thriving.
What Can We Do Better?
- Relevant information should be free and available to all market participants equally. In an era of technology-led innovation, free access to data will encourage more firms to come up with better ways to research funds.
- To avoid the confusion created by numerous media outlets purporting to be experts in fund selection, funds research should be a licensed activity, like it is in some markets. Firms should be free to decide their business model but should publish their track records and notes on possible conflicts of interest on an ongoing basis.
- There should be more research and debate on fund research, which will hopefully lead to better processes and also attract talent.
It is well past time to recognize the importance of funds research, and to bring it into the modern era for better investor outcomes.
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All posts are the opinion of the author. As such, they should not be construed as investment advice, nor do the opinions expressed necessarily reflect the views of CFA Institute or the author’s employer.
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18 thoughts on “Why Good Mutual Fund Research Is Hard to Find”
This is a really nice article.
I would add that quantitative analysis in fund research goes well beyond the specific track record of the fund(s). It should also dive into the underlying portfolio holdings which requires a significant amount of securities analysis as well. If you didn’t perform this task how else would you know if you are adding to a well-priced portfolio? Additionally, if you didn’t perform this task how can you be sure the manager is actually doing what they are saying? In other words, you have to look behind the numbers as they do not tell the entire story nor do they indicate forward looking return potential. My belief is that a strictly quantitative analysis would create an investment process that is not markedly different than performance chasing.
You are right that fund analysis is a terrible amount of work. The detailed level of research required to produce a reasonable list of good forward potential funds is daunting. The research also requires a large number of skills that can all be hard to master. I would add that this is a place where a very good adviser can add a lot of value. I just added a new problem, because good luck finding those.
Qualitative is a bit easier and can boil down to a checklist, that is if you have a good handle on what works over a long time frame.
Anyway, keep up the good thinking.
Thanks Adam. Agree with your comment.
Just one point. Research is such a big task that research houses struggle. It’s a bit too much to expect an individual IFA, no matter how good they are, to be able to do this by him/herself.
Indeed, this is what I will be talking about when I present at the annual conference in Montreal. Hope to see you there.
I have been buried in solicitations from Dan Wiener, who analyzes Vanguard funds for fun and profit. He has a counterpart who does Fidelity funds. Free research is not free. Someone has to pay for it.
The analysis of funds should be done by your portfolio manager, if he is recommending funds for your portfolio. That’s what he is paid for.
My portfolio manager uses a combination of etf’s and stocks to achieve his stated goals. He has done the analysis “under the hood” and several times shared why he has made a change to achieve balance, reduce volatility, or capture an outsized return. He earns his fee accordingly.
I’m excited to hear you will be speaking at the annual conference. I attend almost every year, and the one topic suggestion I always make for future conferences is along the lines of “Investment Manager Selection and/or Mutual Fund Research”. It’s nice to see this finally be an option.
Any practical suggestions for those of us in smaller investment firms will be greatly appreciated. See you in Montreal.
Look forward to meeting you there.
First practical suggestion is to ask your research provider for their investment philosophy and process. See if you agree with it. Also insist on reading the report rather than just relying on the star rating or other symbol.
More when we meet.
Excellent write-up, Hansi.
Almost a universal problem I’d say.
More quantitative hands required to support the economy of research, and perhaps more transparency and disclosures required in the business of the managers.
Yes, technology can bring down the cost of making the data available more widely. Combined with transparency, it can encourage more people to do research.
Thank you for the great piece on the challenges and evolution of manager selection.
A trend that may alleviate some of these challenges in the coming years is wider access to advanced analytic techniques: Indexing and the common sense approach of comparing active managers to passive portfolios were early advances on this road. Similar advances are now taking place in the world of fund selection as consultants, allocators, and fund ranking firms begin to get evaluated on the predictive accuracy of their selections.
Perhaps before too long paying a consultant without a statistically sound record of predictive accuracy will be viewed as at best unwise and at worst source of legal liability.
I look forward to your presentation at the annual conference.
In March, I’ll be speaking at the CFA Institute’s 2016 Wealth Management conference, on “Rethinking Due Diligence and Manager Selection” (very much like the topic that Dave Zandstra said he has been recommending).
If any readers want me to follow up with them on the topic after that conference, please send me a note.
Yes I saw that. Possible to get presentation? Would be interested in different views on the topic.
I too was wondering if it would be possible to get a copy of the presentation.
Hi Hansi .. i have been working on a robo advisory platform and must confess, given my stat background, i always felt the secret sauce to be the algos. I did know that fundamental analysis needs to go hand in hand with the stat part but some of the things mentioned here are eye openers for me. Would it possible to connect via linked in so that i could get your views on how machine learning can help (not the historical data but the qualitative analysis aspects) .. for all i know , you are already aware of research / firms in the area .. appreciate the effort!
Sure send me LinkedIn invite. Or look me up in Montreal if you are coming.
If you do decide to launch a mutual fund and etf independent research firm, what licenses will one need?
Depends on which market. We had to get the investment adviser license in Australia.
Thanks Hansi, I was thinking US, notice that the usual sell side get series 86/87 but those are really meant for equities. Also, morningstar does mutual fund and etf analysis with a rating but they are not a registered financial advisor.
Again rules vary from market to market but in some, if you publish widely, you get classified as media which has exemptions. Personally, I think the journalists should be qualified and licensed, if not the entity, as they are giving general advice. Have written about this too on my site (moneymanagementindia.net)