Morningstar Magazine - October/November 2016 - 63

3 Flows Model Star Rating Model 0 EXHIBIT 3 Accounting for Expenses New funds with high fees not only had trouble posting good results, they also couldn't attract inflows. p Equity p Fixed Income p Allocation % 0 -2 Flows Model Star Rating Model -4 While we can logically reason why an investor may prefer a female portfolio manager, we find mixed effects when studying gender's correlation to higher forward star ratings among new funds. We do not expect gender to be a proxy for skill. High fees hurt flows and future risk-adjusted returns. Fees are one of the most consistent drivers of flows and returns. Higher fees led to lower returns and lower flows across all asset classes for new funds; however, the magnitude relative to other factors is smaller than expected. In our study we control for manager traits, fund structure, portfolio style, firm and category characteristics and macroeconomic environments. Unsurprisingly, fees play an important role in the forward star ratings. A category's most expensive fund could lose out on 3% in terms of riskadjusted returns for equity and allocation funds compared with the cheapest fund. The effect is less dramatic for fixed-income funds, as the difference is only 0.57% risk-adjusted returns on average. The results of the study line up with recent Morningstar research that outlines how fees have a predictive power of success. Therefore, knowing fees could be used as a proxy for forward success, we were surprised to see fees were only, at minimum, the ninth most economically meaningful driver of flows across asset classes. Lowering a fund's expense ratio one percentile relative to the category will boost a fund's forward cumulative flows only a fraction of a percentile for all asset classes. Morningstar coverage is suggestive of higher flows and better investor outcomes. Morningstar analysts are skilled at finding successful new funds, and investors take notice. Across asset classes, funds covered by Morningstar generate higher risk-adjusted returns. The largest effect is in allocation, where there is a maximum increase of 4.7%. The smallest effect is in equity, where we see only a 1.7% maximum benefit. Investors look to Morningstar to perform due diligence and then often follow our advice. The effect of a Morningstar Analyst Rating is immense. The sooner the analyst starts rating the fund, the more time investors have to digest the information and take action. If Morningstar rates an equity fund in the first month, the fund moves into a 14.4% higher category flow percentile. The effect is equally large for allocation funds, where the percentile increase is 13.5%. Interestingly, investors are not valuing the rating as much for a fixedincome fund. During the same time period, the percentile increase was only 0.4%. Style tilts that have resulted in good investor outcomes are not widely preferred by investors. This is the most disappointing finding in our paper from two perspectives: 1) investors don't seem to make good choices when it comes to choosing new funds, and 2) bad choices create a conflict of interest for asset managers. Broadly speaking, we find that investors in new funds prefer to give their money to funds that invest in popular companies that have done well recently even though almost all evidence suggests that the opposite choices result in better investor outcomes. We were able to study this only for equity funds, but, given the magnitude and persistence of these effects in our equity fund sample, we don't hold much optimism for reversed results in fixed-income and allocation asset classes. Conclusion The main result of our paper is twofold. First, investors seem to gravitate toward funds that make them feel more comfortable, with the interests of the fund management company aligned with their own. Investors prefer more information more frequently. Investors like seeing funds helmed by good stewards of capital with managers who have experience and credentials. Firm reputation makes a difference. Managers with "skin-in-the-game" are noticed. In the absence of a track record, investors essentially ask themselves, "Can I trust this manager?" Anything that will likely tilt the answer toward a "yes" shows up materially in aggregate flows. Second, the good news for investors is that their preferences have generally paid off in better outcomes. Funds that exhibit the types of traits listed above are generally the better cohorts of funds from the investor's perspective. The main exception to this comes from investor preference for style tilts, which is directly contrary to their best interests. If portfolios have been disclosed, the investing populace tends to place a premium on funds that buy popular, largecap, overvalued, and liquid stocks that have done well recently. Investors appear to ask themselves, "Have I heard of these stocks?" and respond with additional flows to the new fund when the answer is "yes." Unfortunately, in almost all instances, we would expect the opposite choice to result in a higher expected return. We conclude this paper by highlighting our potential future work. As with most papers, several questions were raised by conducting this analysis. Two stand out: 1 Now that we know something about how new funds succeed, what do we know about why some funds die out? Could we build a model to forecast the probability of liquidation? 2 Investors clearly prefer funds with female management. What is the relationship between the fund industry, investors, and gender more broadly? We anticipate studying these questions and more in the coming months. K Lee Davidson, CFA, is head of quantitative research for Morningstar. Madison Sargis is a quantitative analyst with Morningstar. Tim Strauts is the research and communications team leader for Morningstar. global.morningstar.com/Morningstarmagazine 63 http://global.morningstar.com/Morningstarmagazine

Table of Contents for the Digital Edition of Morningstar Magazine - October/November 2016