IN times of volatility, investors should consider new funds rather than established ones as they tend to outperform in the subsequent years, according to a Morningstar report.

In its quantitative research report, The Rise and Fall of New Funds, it notes that funds launched during periods of economic stress are positive for future performance.

“If a fund is launched during a period of high volatility and falling oil prices, it tends to outperform over the subsequent three-year period. These results are counterintuitive because the instinct is to gravitate toward more established funds during times of market stress. But opportunities often arise during periods of heightened volatility that larger funds can’t take advantage of because the trades are too small to have an impact on their portfolios.”

In contrast, new funds can take advantage of these trades and build up a performance advantage. The benefit of being small, says the report, is strongest in equities because small traders can trade without moving the market.

Conversely, the performance advantage is much smaller for fixed-income funds. That is because being large is an advantage in fixed income, where the best pricing goes to the largest traders. Large firms also get access to new bond issues that a small firm would not get.

The July 19 report explores the relationship between observed investor preferences for and eventual investor outcomes in newly launched funds. The researchers analysed the historical correlation between forward risk-adjusted returns and forward cumulative fund flows of more than 57,000 unique funds globally, evaluating the success factors and common pitfalls of newly launched funds. 

According to the report, global fund flows in 2015 reached about US$516.4 billion across three asset classes — 

equity, fixed income and mixed assets. Of the total, new funds with less than 12 months’ track record accounted for US$379 billion, or 73% of all flows. 

“Even in years when the industry experiences net outflows, new funds continued to garner assets. In 2014, new funds grabbed US$316 billion in net inflows compared with negative US$526 billion in net outflows for funds with more than 12 months’ track record,” says the report.

Although a good chunk of these inflows should be considered seed capital, the report says the simple fact is that capital is consistently being reallocated away from ageing products into newer, fresher and younger funds. 

The report also finds that high fees hurt fund flows and future risk-adjusted returns, as 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. 

“A category’s most expensive fund could lose out on 3% in terms of risk-adjusted returns for equity and allocation [mixed asset] 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,” says the report. 

“For new funds, investors are looking at fees as a decision factor, but are also taking into account other information — the manager, firm and category characteristics — and placing more importance on such factors. Yet, for more mature funds, as a previous Morningstar flows report found, historical performance is the single most important driver of flows.”

Therefore, while fees may not play a significant role in an investor’s decision to buy into a new fund, it will affect a new fund’s track record, which will heavily influence investors’ decisions. 

Portfolio managers have more “skin in the game”, that is, they have their financial interests aligned with those of investors and tend to run higher-quality funds, the report indicates. Investor preference for such ownership outpaces the benefit of higher risk-adjusted returns. 

“In this setting, a typical equity fund will have, on average, 5.5% higher risk-adjusted returns and will move up 6.5% percentiles for flows within its category. For fixed-income and allocation funds, the benefit is more dramatic — 1.9% and 4% increases in risk-adjusted returns, with a 6.9% and 8.9% percentile flows increase, respectively.”

Funds with no manager investment in their funds are effectively sending a signal that the management team’s financial interests are not aligned with those of investors, the report notes. This suggests that the funds may be losing out on future business. 

“Investors appear to be using the ownership reporting data as a filter when deciding between two comparable new funds. In the absence of historical information about a manager’s decision-making, investors are using managers’ financial stakes in new funds as a proxy for their stewardship. The decision to do so has shown to be meaningful and positive in terms of higher forward returns,” it says.

Interestingly, the report notes that style tilts that result in good investor outcomes are not widely preferred by investors. They tend to put their money in new funds that invest in popular companies that have done well recently even though the evidence suggests that the opposite choice would have resulted in better investor outcomes. 

“Investors appear to prefer overvalued stocks when undervalued would have served them better. They prefer large-cap tilts even though small-cap tilts are generally better. They like low volatility even when high volatility results in better outcomes.”

These findings, the report says, suggest that asset managers, to the extent that they know about these investor preferences, are in a real pickle. Do they take style tilts that may be less sexy to investors now but ultimately result in better performance? Or do they tilt in a certain style direction that may be more palatable to investors now at the expense of lower expected returns? 

Further complicating the issue is the fact that the biggest predictor of future fund flows is past performance, the report notes. If the ultimate goal is to garner assets, asset managers are forced to choose between playing the long game and the short one. 

“This also suggests that firms such as Morningstar have an important role to play in continuing investor education. Convincing arguments have been made that suggest we may never see a course correction in aggregate despite the best efforts to educate the investing populace on the types of style tilts they should take,” says the report.

It points out that the preferences of investors have generally paid off with better outcomes, as funds that exhibit the traits listed above are generally better cohorts of funds from the investor’s perspective.

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