Need to Know Your Product? Please Look Beyond Returns

When it comes to understanding investment funds, Morningstar has emphasized the importance of not just focusing on performance and fees, but also understanding the structure, features, and risks associated with each fund – terms that are mentioned quite explicitly in regulatory guidance around the Canadian Client Focused Reforms. Understanding these facets of an investment product is akin to exploring an iceberg, where what you see at the surface is only a small part of the whole picture. 

Above the surface of the water and widely visible to all, are fund returns. These are often the first data points investors look at due to their quantifiable and readily available nature. However, other than provide a snapshot of a fund’s past performance, historical returns don’t tell the investor very much.

Check out the free whitepaper published by Morningstar for a deeper dive into this concept.

Let's have a look at these two funds.

On the surface, both funds look similar in nature, perhaps with Fund B exhibiting slightly more volatility than Fund A. In reality, the funds couldn’t be further form different. Fund A holds a diversified basket of Canadian equities, while Fund B is highly concentrated in Canada’s resources sector, which leads to dramatically different outcomes for investors in different market conditions, and certainly not a comparison of a ‘reasonable range of alternatives’ (another requirement stipulated in the client focused reforms).  

At bare minimum, advisors would be well served to look beneath the iceberg’s surface into the fund’s holdings. Holdings information can give you a clear line of sight into the asset allocation (mix between stocks and bonds), sector concentration, and style biases or factor exposures. For example, is the fund looking for growth companies with consistent earnings? Or is the fund looking for opportunities to exploit undervalued securities, based on fundamental valuation metrics like the P/E ratio? Having detailed holdings information coupled with a strong database of security level information provides insights that are vital when making a product recommendation.  

A snapshot of holdings still doesn’t give you the whole picture though. To make a reasonable recommendation, details around the fund’s operations are quite important as well to answer some core questions that are pivotal to an investment plan. For instance, is the fund actively managed, passively managed, or a combination of both? Does the fund hold other funds? Are derivatives like options and futures being used, and if so, how? For balanced funds, what is an acceptable range of the mix between stocks and bonds? Who manages the fund and how long have they been doing it?  

These dimensions provide insights into the management of the fund that are simply not visible by looking at holdings and returns. Only when an investor understands the stated objective of the investment, and what strategies the fund manager plans to use to achieve them, can they understand and measure whether an investment is meeting those objectives.

Clearly, there is much to consider when making a recommendation to an investor in the context of the Client Focused Reforms. Given that Canadian advisors are already short on time and resources, a look at Morningstar’s forward-looking analysis on funds, which gives a holistic picture of people (quality of the management team), parent (stewardship qualities of the fund company), and process (robustness of investment decision making), alongside performance and price adds valuable insights into a recommendation.  

Read more about our forward looking ratings here.