Morningstar Attacks Fund Stewardship with New “Investor Return”
Here’s an interesting article about Morningstar’s new Investor Return. They’ve correctly identified an interesting anomality in the way performance for mutual funds is measured. It’s essentially the difference between time-weighted and internal rate of returns, with which many advisors may already be familiar.
The way mutual funds measure Total Return, it makes no difference how much money they have under management. If the fund performs at 10% in the first month of the quarter with $1M in the fund, and 0% in the last two months of a quarter when there is $10M in the fund, the average return will be 3.3%.
With their new Investor Return method, the average return for the quarter would be close to 0%. Why? Because the fund doesn’t get much credit for the first month when the fund only had $1M, whereas it had $10M in the last two months (when the return was 0%).
Here’s the interesting part: Why does Morningstar care about measuring this? I mean, the fund companies don’t control when investors invest or withdraw money from their fund. Well apparently they can, according to Don Phillips:
Fund companies don’t have complete control over how investors use their funds, but that doesn’t mean they can’t exercise any control. Fund companies can influence investor behavior through fund design, the timing of launches and closings, marketing efforts, and shareholder communications.
In fact, Phillips indicated that Morningstar was planning on taking a fund’s dollar-weighted returns into account in calculating its stewardship grade. This grade… is based on several different dimensions of a fund’s governance and corporate culture. Phillips argues that a fund probably has serious governance and corporate culture problems if its dollar-weighted returns are a lot lower than its time-weighted returns.
Bam! That’s really putting it out there. I wonder what effect this will have on the industry. Will this bring a resurgence of short-term withdrawal fees?
Mike Benson said,
October 17, 2006 at 11:43 pm
The logic in this article is somewhat flawed. Comparing the dollar weighted return to the time weighted return is a way to measure volatility. About halfway down the page you will see this:
“In contrast, the quartile of funds with the lowest relative volatilities exhibited dollar-weighted returns that, on average, were 98% of their time-weighted returns.”
So what we are really trying to measure is the volatility or risk of the fund and performance is the wrong metric to do that. I do think this is unfair to the fund managers as they really do not have control over the timing of cash flows into or out of the fund.
Sure, as the article points out:
“Fund companies can influence investor behavior through fund design, the timing of launches and closings, marketing efforts, and shareholder communications”
How exactly do I design a low volatility small cap emerging market fund? With all the other solutions (marketing efforts, shareholder communications etc…) I see an increase in fees, how else will the fund company pay for these efforts?
Maybe, as you indicate they will reinstate short-term withdrawal fees which limits the investor’s ability to change funds or goals. However they do it, it means more cost to the investor.
Another solution will be to keep more money in cash, lower returns but also lower volatility. If this measure becomes important this could be a solution, unfortunately it would punish all of us buy and holders with lower returns over time.
What this really tells me is that a lot of investors need better financial managment to help take the knee jerk reactions out. The TWR is the return that an investor will get if they buy and hold the fund. This extra measure is likely to confuse more investors than help them.
Matt Abar said,
October 18, 2006 at 12:16 am
Good points. In regards to a hypothetical small cap fund and whether you would see an increase in fees. It’s far from certain the ultimate solution would raise the cost of the fund. Also, in some cases we’re talking about a 3-4% difference in return numbers. So a minor increase in cost (measured in fractions of a percent) might be justified.
On a side note, I had no idea there was so much fluctuation in assets under management for the large funds. Frankly, I don’t see how there could be such a large variation with these multi-billion dollar funds. In portfolio management software, when there are big differences between IRR and TWR, usually something weird happened. Like a client adding $1M to a $100k account five days before the end of the period.
Bill Ramsay said,
October 23, 2006 at 4:18 pm
Mike I think you’re right about it telling you a lot about volatility, though it may still be beneficial overall. Volatility is I suspect largely a benefit for the most astute investors and mostly a negative for average and poor investors.
In part I believe what Morningstar is trying to do is discourage fund groups and brokers from pushing hot funds, so it could actually lead to lower marketing costs.
I actually question the need for large marketing budgets for funds. If a fund has good results I guarantee that money will find it. If a fund has mediocre or poor results, marketing is all they have to bring in new money.
In addition to not advertising hot funds, fund groups also can (and some have), close funds to new money or as Mike points out raise cash by letting the new money stay in cash. With the latter approach, investors can decide whether they want to hold that much extra cash by moving out of a fund that is doing that, or commiting more money to the fund to keep the same amount in equities (or bonds), though from my experience if we’ve bought an active fund, its because we’ve judged management to be superior in a particular area, and I’m very willing to let them decide if an area is so overvalued that they need to hold a lot of cash- you can look at a fund like First Eagle Global and see that practice has led to higher long term returns not lower.
This new measure certainly won’t be a perfect indicator, particularly if its used to compare single funds to indices. As an example, if you had only $10 million for the first six months of the year, and then $500 mil for the second half of the year, the new indicator would be heavily skewed towards what happened to the markets in the 2nd half. To make any index comparison appropriate, you’d need to know how the $490 million was invested in the first half of the year. I wonder if fund group asset weighted results wouldn’t be a better measure to include in stewardship grades?
In the end, I guess if it reduces how much the industry feeds poor investor behavior it would be a good thing.