You may be able to add up to 200 basis points of excess return when a fund’s handicaps are applied as a supplemental assessment to Morningstar gold-rated funds.
Fund selection is a complex process. Beyond the suitability aspects, there are hundreds of proposed performance measures, third-party metrics, analytical processes, and due diligence discussions to assess funds. Among them, Morningstar ratings are quite popular as an analytical metric. Given Morningstar’s reputation, even if we assume that they look at all the traditional and some proprietary measures in rating mutual funds, we are still left with more than a handful of similarly rated funds for each asset class. For example, if we use the forward-looking medalist ratings, there are several gold-rated funds from which to choose. If Morningstar ratings are a filtering criterion, how do you incrementally assess all the gold-rated funds?
Q2 2023 hedge fund letters, conferences and more
We propose fund Handicaps as a supplemental assessment data point.
As background, in our May 22nd Advisor Perspectives article, we introduced the Advisor Assessment Framework with its three-core metrics:
- Score – shorter-period performance path profile relative to the benchmark, as a risk attitude trend measure;
- Handicap – average longer-period performance path profile relative to the benchmark, as a stable risk attitude measure; and
- Fairway average – the propensity to take risk relative to the benchmark, as a risk attitude beta measure.
Collectively they provide insights around the asset’s (or advisor-recommended portfolio’s) risk-taking as it navigates a benchmark. While the Advisor Assessment measures are meant to complement each other, the final weighting for a measure can depend on the objective.
Morningstar gold-rated funds
We construct a very simple test and demonstrate results for three equity asset classes – small-, mid-and large-cap mutual funds. Since the allocation to a fund can be made at any time, we evaluate the selection performance on a rolling basis. Every month we take all the funds rated gold by Morningstar and assess their excess performance (versus the relative index) at the end of the investment period (or 1, 2- or 3 years forward). Similarly, we take the same gold-rated funds and apply a filter of the funds that also were in the top 50% of the Advisor Assessment measures for that month and asset class. Then we evaluate their excess performance (versus the benchmark) at the end of the investment period (or 1, 2- or 3 years forward). Our results are based on the averages of all selected funds, where extensions can be applied.
Read the full article here by Dr. Ali Hirsa, Satyan Malhotra, Advisor Perspectives.
