How to Research & Choose Managed Funds

© 2009 Michael Lannon

When it comes to investing in managed funds and superannuation, many investors are uncertain of how to go about researching and comparing the available products. Many seek the assistance of a financial planner but are then charged high entry fees and commissions. The following article is intended to educate readers on how to interpret the available independent research and ratings, as well as provide information on other considerations when comparing funds.

There are literally thousands of managed funds and superannuation funds available in Australia. The vast majority of these funds are owned by banks and insurance companies which in turn own financial planning companies that recommend their corporate owner’s “in-house” products, making the advice one receives potentially subjected to bias. Investors can find factual information combined with promotional information on the company’s managed funds in advertisements and on company websites but the key questions remains: 

How is an investor supposed to sort through the range of products and get unbiased assessments of their relative investment merit? Where can an investor find this information?

Luckily there are a couple of independent fund research companies that research managed funds and assign ratings. Research on Australian managed funds is provided by Morningstar and Standard & Poor’s, both of whom provide ratings on thousands of funds. By using independent ratings, individual investors are able to harness the resources and expertise of these two research houses in developing their own investment portfolio.

In the past financial planning firms paid for access to this information and in turn passed the information onto investors. Nowadays investors can directly access this information via websites that target DIY investors, as well as in the “money” or “investment” sections of main newspapers. Investors are able to access comprehensive performance data, fee information, asset allocation and independent fund rating information which can make the process of selecting and monitoring an investment fund a whole lot simpler.

STAR RATINGS - WHAT THE RATINGS MEAN

Most investors will have seen fund star ratings in the newspapers, but many do not know what these ratings actually mean.

Morningstar

Morningstar fund ratings is calculated every month and are based on a 40:60 split of the rolling three year and five year performance “risk- adjusted return”. This split is designed to reward consistent performance and to minimise short-term variations in performance. Morningstar uses categories to group similar-style funds together to ensure that a fund’s Morningstar Rating is relative to other funds in the same peer group.

Following a Bell Curve, the top 10% of funds rated are allocated a Morningstar Rating of 5 stars, the next 22.5% are allocated 4 stars, and the next 35% of funds 3 stars.

Standard & Poor’s

Standard & Poor’s ratings are arguably more meaningful due to their combined qualitative and quantitative basis. Standard & Poor’s ratings involve interview based-research and analysis, and are designed to provide investors with both an absolute option on whether a fund meets certain minimum standards and a relative perspective on where a fund falls among its peers.

Only funds that are considered by researchers to consistently generate “superior risk-adjusted fund returns, net of fees, relative to relevant investment objectives and peers” are granted a 4 or 5 star rating, dependent on Standard & Poor’s “level of conviction”.

Standard & Poor’s similarly apply a peer group approach, allowing for the comparison of funds within specific asset classes. Their qualitative approach allows ratings to be much more forward looking though, accepting that the track record of the investment manager may be an important reference, but that past performance is no guarantee of future performance.

FEES

Entry fees and management fees should also be considered when researching managed funds, as small differences in fees and costs can have a substantial impact on your long term returns. Entry fees of 4% to 5% are charged by most managed funds on your initial investment as well as all additional investments or contributions. By investing through a direct investment broker you can get a full rebate of the entry fee so that all your money goes to work from day one.

DIVERSIFICATION REDUCES RISK

In selecting your investments, it is worth developing an asset allocation plan that spreads your investments across a range of assets. Your investment plan should include a mix of investments from different sector of the financial market. That way you won’t have all your eggs in one basket and your financial future won’t be solely dependant upon the returns of a single type of fund, investment or asset category.

MONITORING YOUR FUNDS

Once you have invested, you should periodically review the performance of the selected funds and monitor those funds that are re-rated by Standard & Poor’s and Morningstar. You can easily monitor ratings changes by subscribing to online investment newsletters that highlight the changes in funds ratings. Very often when the investment manager changes or there are risk management issues with a fund either Morningstar or Standard & Poor’s will put the fund rating “On Hold” or downgrade the fund’s rating. When this happens and you are invested in that fund you should monitor the situation closely and determine whether you wish to continue your investment in that fund.

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Michaell Lannon is the Managing Director of 2020 DIRECTINVEST, a boutique investment company offering direct access to managed funds and super funds without entry fees and adviser service fees. He has more than 20 years experience in the financial services industry, initially with Merrill Lynch in Canada and Australia before founding 2020 DIRECTINVEST, and is a vocal critic of inadequate fee disclosure and commission-based financial advice.

This article contains general information only and does not take into account the particular financial situation, objectives or needs of individual investors. Investors should consider whether this information is appropriate in light of their particular financial circumstances before investing, and if necessary seek professional advice.