During the Morningstar Investment Conference, Nikunj Dalmia, Senior Editor at ET Now, spoke to Kunal Kapoor, Chief Executive Officer, Morningstar Inc. Below is an excerpt from the conversation.
In the 20 years, you've been with Morningstar, you would have looked at hundreds of funds. What makes a good fund different from a bad one? What makes a good AMC different from the bad one?
I think I would phrase your question a little bit differently. It's not about what makes a good fund or a bad fund. It's what makes a good investor versus a bad investor, because you can pick the best fund in the world but if you are a terrible investor, you are going to still have a bad outcome. And what I mean by that is that you really have to have discipline in the funds that you are investing in to stay in them when it's the hardest time to stay in them.
Personally, once I pick a fund, I generally only add money to the fund when it's underperforming. This may seem counter to what a lot of people would think, but I do that because I think any fund will go through periods of underperformance. There is no investment that is a straight line up. The key is to have the discipline when things look horrible to actually go in there and make the adjustments that need to be made. So, I think, being a good investor is partly having the discipline of building a portfolio and then meaningfully sticking with that portfolio over time.
But to answer your question: low fees matter. So, a really quick way to dissect the universe is simply by cutting out the portion of funds that are overcharging.
When you are looking at an asset manager, you really must get a sense of how the managers themselves invest. So, if they are eating their own cooking and buying their own funds, you are likely in a situation where there is more alignment versus the situation where there's a manager who is not buying his own funds. That tells you something.
Where are you on the active versus passive debate?
In my mind, it's not active versus passive. It's fundamentally a low cost versus high cost debate. I am personally almost 100% in active management myself. I believe in it. But by the same token, I think the active management industry makes a lot of lame excuses for what they do sometimes. The reality is that if you are an active fund, you need to earn your keep. So, I am a big fan of active, but they have to earn their keep and I think a lot of active funds do not.
That is where advisers have an opportunity. That is where they add value to their clients. There certainly is an entire universe of active funds that we could do without, but there are a lot of good active funds out there with very reasonable fees that are worth considering.
When we talk about good funds versus bad funds, you mentioned the cost aspect. Is that the biggest differentiating factor?
In terms of performance and whether funds do well or not, yes. All our data suggests that cost is the number one predictor of future performance.
Then why go for active?
There are lots of active funds with reasonable costs.
If you look at the Morningstar Star Rating as well, we've shown that higher rated funds tend to outperform and a lot of them are active funds. But you need to own them for long-term periods; you need to make sure they are reasonably priced. What you don't want is the active funds that are charging several times more than what the typical fund would charge. But look for funds in categories that we have that are below average and start there. There's lots of good funds to pick from just with that group.
Give me a sense of what do you define as consistency because in the financial industry it's very important to knock off the volatility and focus on the consistency.
Well, there is no such thing as pure consistency. You are never going to get something that goes up in a straight line and that you can say is going to do that. But consistency is essentially investments that over market cycles deliver a similar experience to what you would expect.
Some funds by nature are more conservative and you would expect that in up markets, they will underperform. But in down markets, they'll protect your capital. So, you should know as an investor or an adviser going into an investment like that that that's what to expect and if the fund does that, that's okay. When it underperforms in an upmarket because it's more conservative, that's not a bad thing. You have to kind of have that mentality and approach upfront so that you can actually go through that.