Our US correspondent examines what industry figures think is the best way to judge the skills and effectiveness of fund managers.

(An earlier version of this article appeared in Family Wealth Report, sister news service to this one. Given the cross-border nature of so much investing and the global relevance of the points made, we hope readers beyond the US find this of value.)

For fund managers, being followed by a Morningstar analyst is like a publicly traded company being selected for the Dow Jones Industrial Average. It’s a big deal.

But what are Morningstar analysts looking for when they track a fund and interview a manager?

“I want to see if managers are doing what they’re trying to do,” said Elizabeth Foos, research manager for multi-asset and alternative strategies at Morningstar, speaking at the firm’s annual Investment Conference in Chicago. “I want to see if their process is consistent, robust and repeatable. How do they approach risk management? Are they able to attract and retain talent?”

The philosophy of the firm is central for Eric Jacobson, senior principal at Morningstar. “Does the firm have an investment culture or is it a business with a distribution arm selling product?” Jacobson said. “Does the CEO allow investment managers to make important decisions? If the CEO wants to launch a product, will he or she defer if the chief investment officer says it’s not the right time?” 

How a fund presents itself is important for Andrew Daniels, equity strategies director at Morningstar. “How a fund presents its strategy says a lot about their culture,” according to Daniels. “If they pitch aggressively, it can reflect poor investment approaches. And being forthright when communicating is very important, especially when things go wrong.”

Interviews
Perhaps surprisingly, Foos said that when she interviews a fund manager, she’s not collecting information, but validating what she already thinks she knows. “I’m looking for patterns,” she said. “What is the story behind the numbers? Is the strategy acting as expected? Who is making decisions? Is the fund retaining talent? Are they collaborative?” 

Temperament is key for Daniels in interviews. He likes to push manager’s buttons by asking about poor performing stocks to see how they respond. “There’s a fine line between confidence and arrogance,” he said.

If a fund manager says they’re quality-oriented but some of their portfolio picks don’t reflect that, Daniels said he will “press” the manager about it in an interview to see how they respond.

“They may have a good reason or they may be stretching it,” he said. “If there’s portfolio turnover, are they being too short-term oriented? Have they broken their thesis for buying the stock? Are they being stubborn? And if portfolio turnover is too low, are they being too complacent?”

Red flags
Asked what raises concerns about fund managers, Jacobson said he’s alarmed “if a manager is completely focused on their peer group and why his fund is better than what other funds have done.” He also finds it concerning when managers say what they’re doing is unique, when it clearly isn’t. “It’s worrying,” Jacobson said, “because they may be living in a bubble.”

A red flag for Foos is a mismatch between stated strategy and performance. “If a manager says its selection but performance is really driven by a sector or the market environment, we have to dig deeper.”

Manager red flags for Jacobson include much higher performance than a peer group, higher fee levels, which puts additional pressure on managers to beat benchmarks, and not being aware of what peers are doing. “They may still be using the same tools as 15 years ago,” he said.

All the Morningstar analysts said they’re using artificial intelligence to help them identify patterns in funds they cover and ask better questions. But in the end, Daniels said, “it’s really a people assessment business.”

(To see previous reports from the Morningstar event, click here and here.)