Beyond Returns: Three Powerful Factors in Active Fund Evaluation

A common approach by investors is to invest in funds that have historically outperformed their benchmark index, hoping that a fund’s past outperformance will continue. Our research finds this approach can often work — until it doesn’t. We see a persistence effect in fund performance data, whereby funds with strong three-year performance often have another three-years of good performance in the following period. But when the relationship breaks down, it is often painful. The prior winners tend to become losers around big inflection points in the market, such as the 2008 Global Financial Crisis and the 2022 sell-off for stocks and bonds induced by rising interest rates.

We believe investors should consider a fund’s past performance as an important criterion. We also believe it is important to review factors outside of performance, not because performance doesn’t matter, but because certain non-performance factors have been shown to correlate with future performance. In other words, investors may benefit from expanding their criteria beyond performance. Here, we highlight three non-performance indicators supported by academic literature: fund expenses, team-based management, and ownership of fund shares by portfolio managers (PMs).

Fund Expenses

• The evidence. There is generally broad agreement among peer-reviewed academic literature that funds with lower fees generally have better performance. A somewhat recent example comes from Michael J. Cooper, Michael Halling, and Wenhao Yang (2021), who found “a strong negative association between net-of-fee fund performance and fees in a sample of all US and international equity funds.”¹
• On your own. You can find a fund’s fees and expenses in its prospectus document and can compare them to other funds in its asset class using third-party data providers.
• Go further with LPL Research. We assess fund expenses as one factor in our 40-factor evaluation framework. Funds with expenses below the average for their investment category generally receive a green status in our framework. When fees are above average, we prefer to see this offset by strong net-of-fee performance and a reasonable explanation for the higher fee (such as higher costs of resources and data in complex assets). We also evaluate trading costs, such as explicit trading commissions and, for exchange-traded funds (ETFs), implicit costs such as the bid-ask spreads and premiums or discounts to net asset value (NAV).

Team-Based Management

• The evidence. Saurin Patel and Sergei Sarkissian published a paper in 2017 that found that team-based funds generally perform better than funds with a single manager.² They also found that having too many PMs on a fund is associated with underperformance. 
• On your own. You can find the names and basic biographic information about a fund’s PMs in its prospectus.
• Go further with LPL Research. Our Investment Manager Research team speaks with PMs on an ongoing basis. Sometimes we uncover nuances, such as key investment professionals who are not listed in the prospectus but still have important roles on the investment team. We also find situations where someone is listed in the prospectus as a PM who does not make day-to-day investment decisions for the fund, but rather provides an oversight function. Through our conversations with PMs and other key staff, we develop an opinion of the key contributors to a fund’s success, and we stand ready to adjust our opinion of the fund when key people depart. We also attempt to understand the communication dynamics on an investment team, as healthy two-way dialog about portfolio decisions may be helpful to performance.

Ownership of Fund Shares by PMs

• The evidence. An article by Khorana, Servaes, and Wedge (2007), as well as more recent studies, find that funds whose PMs invest their personal assets alongside investors tend to have better performance.³  Some observers believe this comes from managers having “skin in the game,” because they do better financially when the fund succeeds. 
• On your own. You can find the PM’s ownership of fund shares in a fund’s Statement of Additional Information (SAI), which is typically available on the fund company’s website. Within the document, searching for the PM’s last name may help you find the relevant section among this lengthy document.
• Go further with LPL Research. We assess PM ownership as part of our 40-factor evaluation process. High ownership of fund shares tends to receive a green indicator in our framework, while little to no ownership tends to receive a yellow or orange indicator. If a fund manager does not own shares in the fund they manage, we typically inquire with the manager about this and determine whether the explanation addresses our concerns. For example, the PM may be aligned with shareholder interests in other important ways, such as through a well-designed performance-based compensation plan or investments in similarly managed portfolios.

Final Thoughts

We believe it is important for investors to consider a fund’s past performance and factors beyond performance. The importance of fund expenses, team structure and dynamics, and PM ownership of fund shares are well-supported by academic literature and our internal research. While investors can find relevant information in fund documents, our Investment Manager Research team dives much deeper. We do this by considering implicit as well as explicit costs, regularly speaking with PMs, and understanding how they are incentivized. We believe these are important aspects of our overall, holistic 40-factor evaluation framework for actively managed portfolios.

Footnotes

1. Michael J Cooper, Michael Halling, and Wenhao Yang, 2021. "The Persistence of Fee Dispersion among Mutual Funds." Review of Finance, European Finance Association, vol. 25(2), pages 365-402.
2. Saurin Patel and Sergei Sarkissian, 2017. “To Group or Not to Group? Evidence from Mutual Fund Databases.” Journal of Financial and Quantitative Analysis, vol. 52(5), pages 1989-2021.
3. Ajay Khorana, Henri Servaes, and Lei Wedge, 2007. “Portfolio Manager Ownership and Fund Performance.” Journal of Financial Economics, vol. 85, pages 179-204.