Fund providers should go well beyond disclosing merely the top ten holdings of the funds, says Thomas Lancereau of Morningstar.
Mutual funds are fantastic financial instruments. They allow investors to access the security selection of managers with expertise across the equity and fixed income spectrums. When an investor entrusts money with an asset manager, trust plays a critical role. The highest standards of transparency should be adopted in order to maintain that trust over time.
There are many ways for the asset management industry to raise the level of transparency, and a good starting point is the disclosure of portfolio holdings. Investors tend to hold many funds, so portfolio holdings information is crucial in understanding how they interact. This information also helps the investor understand the level of risk for each fund, and over time, whether or not the fund still contributes to their investment objectives.
To achieve that, it’s paramount to go well beyond the disclosure of the top ten holdings, a common practice in the industry. Investors must know the portfolio’s complete holdings. The fund’s annual report contains that information, but because it is only disclosed once a year, there is often a considerable time lag that makes it difficult for investors to use the information.
Fund managers may not to want to disclose their most recent investment decisions, particularly when trading less liquid issues, which could harm their execution and ultimately the fund’s returns. While a legitimate concern for some funds, there is certainly considerable room for improvement in today’s disclosure. In the US, for instance, portfolio holdings must be disclosed on a quarterly basis and with a maximum lag of 60 days after the end of each quarter.
While the former is a legal minimum, many asset managers have opted for a monthly frequency with a one-month lag (sometimes with no lag). These include some of the largest managers in the world who, given the scale of their assets, are among the most concerned about avoiding front-running and keeping trading costs low. That even these managers are able to provide regular, monthly disclosure is a telling point. Further, such disclosure has not prevented good managers from producing superior risk-adjusted returns for long-term investors.
Another area where disclosure could be improved is on fund managers’ personal investments in the portfolios they run. Our research has shown a significant relationship between the manager’s personal investment in the fund and its risk-adjusted performance over time. After all, it is legitimate to ask if the chef eats his own cooking. This information gives a clear signal of confidence to an investor considering a new fund but also, and perhaps more importantly, in times of short-term underperformance. It also helps ensure that the manager’s interests are aligned with those of the investors in his fund.
COMPENSATION
At a time when discussions on bonuses are quite virulent, it seems reasonable to require more transparency on the mechanisms used to calculate variable compensation for fund managers. There should be some relationship between the compensation policy and the time horizon of the fund managers’ investment decisions.
At Morningstar, we believe that bonuses based on three to five-year periods should encourage the development of long-term-oriented investment strategies. On the other hand, shorter time periods in bonus calculations can incentivise managers to take large short-term risks as they know they will not be penalised for this except for a short period. It can also encourage more rapid trading, which implies higher trading costs to fund investors.
At some asset management firms, performance plays a minor role in calculating bonuses. Instead bonuses may be tied to the managers’ efforts to improve relationships with distribution channels, in which case it’s reasonably clear that asset growth is favoured over long-term results, which is something we view as a poor practice not in keeping with the interests of fund investors.
Ultimately, the decision on how to compensate its managers should be determined by the asset management company according to its own priorities and objectives. That said, we think investors have the right to know that information. With such disclosure, it’s likely that fund managers’ compensation would evolve towards a system that would better align their interests with those of fundholders.
In their effort to enhance transparency, fund companies should also pay close attention to the quality and utility of the information they give. Unfortunately, the content of management reports doesn’t tend to be very useful. A vague comment on the evolution of markets and the macroeconomic environment does not help the investor understand the nature of a financial product. Commentary on the fund’s performance versus its benchmarks over the past quarter also fails to educate investors on the merits of the strategy. Thoughtful communication that explains the management strategy, why certain securities are selected and how they’ve performed is much more valuable. When the strategy and risks of a fund are clearly explained, the case may not appeal to all potential investors. But by failing to do so at all, an asset manager takes the bigger risk of disappointing fundholders.
Thomas Lancereau is director of fund analysis at Morningstar France
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