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Chris Douglas, director, manager research ratings, Asia-Pacific, Morningstar Inc.
Chris Douglas, director, manager research ratings, Asia-Pacific, Morningstar Inc.

Our analysts are entitled to an opinion, but opinion has to be backed by data

Chris Douglas about the challenges of doing analyst ratings and what more his company tells us in addition to its star ratings

Morningstar, one of the world’s largest mutual fund research firms, rates fund houses the world over. But it doesn’t just focus on its star ratings, which look at historical data and aren’t quite forward looking. Past performance, as is well known to all of us, does not guarantee future performance. Here’s where it’s analyst ratings comes in. Here Morningstar goes behind the scenes, interviews fund managers and houses on a consistent basis and goes into their teams, processes and philosophy to bring out the analyst ratings. It does the analyst ratings for India too. Chris Douglas, spoke with us about the challenges of doing analyst ratings and what more they tell us in addition to its star ratings.

Tell us something about Morningstar’s analyst ratings.

The focus of our ratings is very much forward-looking. Apart from the star ratings that look at risk-adjusted performances of funds over various time periods, we also do analyst ratings. Here, our analysts sit with fund managers and rate the funds on five pillars: people, process, performance, parent and price. This way, we’re making judgements on the investment team, their process, how funds have performed in different market conditions, what sort of fees they charge, their parents’ culture, and stewardship of the firm. That’s how we make a forward-looking projection of how the fund is likely to go.

Star rating is not a part of the analyst ratings. Analyst ratings looks at performance too, but we do a lot more work here than just look at the risk-adjusted returns that we do in the star ratings. In analyst ratings, we look at performance; performance in different market conditions; how performance has been relative to our expectations. In analyst ratings, we look at other qualitative factors and not just performance (which has low weightage in analyst ratings) because through it, we want to take a look at how this fund is poised for the future.

What information do you look at from the fund management teams?

We look at the investment team managing the fund. What does the analyst team looks like, their experience, stability and their expertise. Then, we look at the processes, we understand how this fund works; like how does a fund house narrow down to a basket of funds, out of a large investment universe.

We also look at how often they churn their portfolios, what’s the typical holding period of an investment in their funds, what risks and vices do they have in their portfolios. Do they take a lot of risk vis-a-vis the index, are they active on cash (holdings), what has been the market capitalisation of the portfolio and does it move up or down and if so, by how much, things like that. We also focus on parents of the firm. We look at whether the fund houses have a salesmanship culture, do they have a tendency to bring out a lot of trendy schemes, do they tend to follow fads and so on.

Don’t you think that could be subjective? How do you define the sales culture of a fund house?

Morningstar started off as a data business. So, we have a...tremendous amount of information on these funds. And we like to make sure that any decision we make is backed up by evidence or data. So...we can look at portfolios over time and see how they have changed over time. We collect lot of information on people; everything we need to know about the portfolio manager and how big the investment teams are, their experiences, etc. We ask a lot of questions on remuneration and compensation structure and if they are rewarded for long term performance, and so on.

Yes, its subjective but based on the sort of data we collect on the five pillars we spoke about earlier; there could be evidence to point out that the sales culture of a fund house gravitates towards launching fad funds or not. Our analysts are entitled to form an opinion, but such an opinion has to be backed by evidence in the form of data.

What is important to you, processes or people? In houses say they have processes but many large fund houses have had these star funds managers. They have a good track record, but fund house get known more by such names than their processes. Abroad, when assessing funds, do you pay more attention to processes or people?

I’ve lived in London, Chicago…and I can tell you right now that the star portfolio manager mentality is global. It’s not just in India. At the very top is Warren Buffet. In every other country around the world, there are fund managers working that come with a high profile, across different firms. Some businesses have different investment structures. They have multi-portfolio structures for instance, so they’re trying to move away from the star fund manager culture. Few others have quantitative models as well when it comes to picking stocks, instead of relying on fund managers.

I would say that we, at Morningstar, look through the noise, we understand what this means for investors going forward. So, we don’t necessarily have a problem with the star fund manager mentality but we have to understand what the team is like below them. It is also important to understand whether or not they’re going to hang around and look after investors. At the end of the day, you can look at their behaviours, you can look at the style of investing, you can look at how they engage with their investors and their clients. And whether they are acting in their investors’ interests.

How important are processes and how do you measure that?

You need a process. “If you don’t stand for something, you fall for everything," goes a famous quote. If a fund house doesn’t have clear and disciplined processes, how is it going to truly manage money? It’s important that the fund house, at the start, understand what its skill sets are; what it believes in fundamentally, when it comes to investing; does it believe in being a value-oriented manager, holding companies to the point when they reach their intrinsic value, or does it believe in growth-oriented companies with high earnings per shares that can drive future returns?

When looking at the investors, they have to understand what their philosophy is, what their strengths are, and how they’re going to add value, and build a process around that.

Around the world and especially in India, there is a lot of different ways you can invest. And even around the securities, there are challenges around transparency, around performance reporting, benchmarking, etc. So fund managers have to really understand what they stand for and build a process around that. We spend a lot of time understanding that. Analysts sit with portfolios managers, and hopefully the investment team as well, to ask questions on funds, processes, people, performance, and so on.

Have you brought these ratings to India?

Yes, we have. We track about 850 mutual fund schemes in India for our analyst ratings.

How do you assess truthfulness of the information that fund managers give? Give me an example of how information can change after you scratch the surface.

Take the case of fund managers or analysts leaving. Often managers might say a senior analyst resigned moving on to another role and the team would take over that analyst’s responsibilities. In some cases, we have found, upon digging, that the analyst was perhaps asked to go because the fund house was trying to reduce costs. That could be because the fund house hasn’t grown to the extent it expected. Fund managers or firms would try to put a positive spin on negative information. For instance, some fund houses claim to follow a ‘value’ style of investing. But on going through their portfolios, we realise that they churn their portfolios. That is not ‘value’ style of investing, for sure. It’s all about asking the right questions and looking past the information

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