Christine Benz. I’m Christine Benz for Morningstar. I’m here at the Morningstar Ibbotson Conference, where I recently had the opportunity to sit down with Bill Harding; he is the head of manager research for Morningstar Investment Management. He shared some tips for identifying fund managers who will outperform in the future.

Christine Benz. Bill, thank you so much for being here.

Bill Harding. Thanks, Christine.

Benz. Well, this morning, Bill, you discussed some of the things that you look at when researching managers, some of the key factors that you prioritize when deciding whether to select fund managers for Morningstar Investment Management.

Can you walk us through some of those factors, say, for individual investors who are attempting to select fund managers. What should they stay attuned to?

Harding: Well, at a broad level we combine quantitative analysis with qualitative due diligence. So on the quantitative side, we’re looking at performance metrics, risk-adjusted results, to try to identify whether a manager has shown the ability to add skill in the past. And on the qualitative side, we’re really digging into the people, the process, the depth of the investment team, what their capabilities are, and whether we think what led to the good past performance is in place to produce good performance going forward.

Benz. So I want to back up to the quantitative piece, looking at risk-adjusted performance. Is that at all predictive in your research? Should people focus on that? Because I think a lot of times individual investors focus on past performance to their detriment. They go with the hot performer, and they assume that it will be able to continue its great run?

Harding : It’s easy to focus too much on the performance, but at the end of the day, individuals are trying to find managers that can outperform a benchmark after their fees. So really that’s what they are getting at.

So, some academic research has shown that some performance is persistent and that shorter-term measures of alpha over one- to three-year periods, there is some persistency in that. So I think it could be helpful for individuals to maybe focus a little bit on performance, but it has to be risk-adjusted, looking at an alpha metric or other metrics that take into account the risk that a manager is taking on.

Benz. So do you think that’s kind of a momentum effect that those studies are capturing, that show that outperformance on a short-term basis might be somewhat predictive?

Harding. Actually a lot of these academic research studies that have shown performance persistence over one to three years actually have based it on a Carhart three-factor model where they are kind of isolating the effects of stock selection, and accounting for the momentum value and size effect. So it should already take that into consideration.

Benz. So, in terms of the more qualitative factors, evaluating quality of management, if I am an individual investor and I can’t get in to sit down with a fund manager, how do I begin to get my arms around whether the manager has what it takes to be a good performer in the future?

Harding. There is a lot of information available now without having to sit down directly with the portfolio manager.

First and foremost, researching the manager and their background on Morningstar.com or other sources. You can go directly to fund company websites—that’s often a good source of information about the management team, the investment process they employ, and I’d also advocate reading SEC filings, reading past shareholder letters that the fund team has written to, again, try to understand how they go about selecting stocks or bonds, and go about managing risks in their portfolio.

Benz. I know you also stay attuned to what we call broadly stewardship.. If I’m an individual investor trying to pick managers at home, what are the things that I should be looking for when attempting to see if a fund is a good steward? Of course I can read our  Stewardship Grade. if it’s on the site [morningstar.com]?

Harding. You get [Morningstar’s] Stewardship Grade, that would it be a good short cut. But I think one easy metric to look at is ownership. We like to see our managers eat their own cooking. So, they are now required to report their ownership in the funds that they manage through SEC filings, and again various Morningstar tools will provide that information as well. So that’s an easy [indicator]—is this manager invested alongside the shareholders, are their interests somewhat aligned? So that’s one thing I would do.

And other factors, other ways to try to get at stewardship, I would be again looking at information available on the fund company’s website, trying to determine what kind of culture they have at the firm. Are they focused on investors first and so forth? Sometimes you can pick some of those cues up in commentaries they have written or other materials they have on their website.

Benz. So with manager ownership, do you see anything to suggest that that is somewhat predictive, that a manager who owns his or her own fund tends to deliver better returns?

Harding. Yes. Morningstar did a study last year, a stewardship study, where they looked at various factors that they evaluate for their Stewardship Grade to determine which factors might inform future performance, and manager ownership did seem to have some predictive capabilities in that. Managers that invested more of their money in the fund did provide better risk-adjusted performance in the future than those managers who had lower ownership stakes.

Benz. Once I have selected a manager—and that’s obviously quite a bit of work as you’ve ticked off a lot of factors that you need to stay attuned to—how should I monitor an active fund on an ongoing basis to make sure that it’s doing what I need it to do, and also are there any red flags that I should be looking out for when monitoring a manager?

Harding. So one of the challenges with investing and selecting active funds is that they can change over time, their characteristics. So things that were in place that led to past performance that was good and provided alpha may not persist over time due to various reasons.

So some of the things that we look for would be organizational instability, manager changes, and that’s easy to find on websites, through SEC filings. If there is a manager change, they have to file a prospectus note; this is information Morningstar has as well. So, that’s a key red flag if there is significant manager change.

Benz. Sometimes it’s not bad though, right…

Harding. Some manager changes, right.

Benz. …sometimes it’s a carefully groomed successor, so it’s not an automatic sell, but a red flag, you could say.

Harding. At least a reason to revisit, make sure that the investment thesis that you originally invested in that fund for is in place. So as you mentioned, sometimes it’s well planned out ahead of times, succession planning, etc. or the team is deep, so the loss of one portfolio manager might not be a significant event.

Other factors to consider would be characteristics of the fund more on the portfolio level. Has its style changed over time? Did you buy it to invest in small-company stocks and now it’s invested more in mid- to larger caps? So again that information is available in various ways. You can look at the holdings. overlap, you can look at the style box information on the Morningstar tools, to try to get a gauge of what types of stocks the fund is investing in.

Benz. How about asset size. I know a lot of times when funds stumble, investors say, Aha! It got too big. How should investors gauge that question? How should they know if a fund is too big?

Harding. It’s hard to have a definitive rule to say when it gets too big. I would say you can look for clues or evidence to see whether asset size is starting to play a role in how they manage the fund, and you often see characteristics of the portfolio change. So you may see the number of holdings that the manager owns increase. Maybe in the past, they have owned 50 to 60 stocks, and now they are trying around 100-120. Is that really the level that the manager would optimally want to run that fund at?

You also might see an increase in the number of larger-cap or mid-cap stocks that they own, or average market cap, etc. Another metric you might see is how active the fund is, or active share—how it deviates from the benchmark, whether it’s becoming more index-like over time as the asset level increases.

Benz. Should I be more attuned to asset bloat at a small-cap fund or one that is focusing on smaller stocks, or is it across the board something that I should be paying attention to?

Harding. Asset bloat and capacity seems to be a little bit more of a concern in less liquid areas in the market, such as small-cap stocks or high-yield bonds, but it also can play a role in larger funds as well. I think the key is to really try to figure out the strategy, the investment style, the manager, if they run a fairly concentrated portfolio, even if it’s in mid- to larger-cap companies, they might not be able to handle as much in assets, say, as a small-cap manager that runs 400 stocks in their portfolio and is more index-like. So, I think it will depend on the investment style, the strategy that they employ, and just how do you think capacity might potentially impact that.

One thing we do when we talk to managers is try to address capacity right up front. Try to understand, is there an optimum level of assets that they feel comfortable managing, what steps will they take to curtail asset growth as they approach that capacity limit—just to make sure that they are thinking about serving the best interests of the current shareholders and not just trying to gather as many dollars as they can.

Benz. So you want to see managers who have been proactive about that question.

Well, Bill, I know you’re in the trenches in terms of selecting managers and researching managers. So we really appreciate you sharing these insights with us. Thank you so much for being here.

Harding. Thanks, Christine.