Investors
are
always
on
the
lookout
for
winners,
but
knowing
how
to
keep
the
losers
out
of
your
portfolio
should
be
just
as
important.  

High
fees,
the
departure
of
a
solid
manager,
or
a
focus
on
an
overhyped
asset
class

these
are
some
of
the
“red
flags”
that
can
erode
returns,
or
may
even
indicate
a
fund
is
on
the
verge
of
shutting
down. 

I
sat
down
with
Morningstar’s
director
of
manager
research
Michael
Malseed
to
identify
some
of
the
major
warnings
signs
investors
should
watch
out
for

whether
investing
in
a
fund
for
the
first
time,
or
for
an
existing
holding.

While
this
article
focuses
on
investment
red
flags,
we
have
a
wealth
of
resources
to
help
readers
learn
more
about
fund
investing,
follow
the
links
below
for
more: 


Considering
an
Investment?
Watch
Out
for
These:

A
useful
starting
point
for
investors
deciding
where
to
invest
is
the
Morningstar
“medalist”
rating,
which
evaluates
whether
a
fund
will
be
able
to
produce
excess
returns
after
fees, in
the
future.
(Our
medalist
rating
has

recently
been
overhauled
 –
see
here
for
more.)

Our
tracking
shows
that
on
aggregate,
medalist-rated
(gold/silver/bronze)
funds
outperformed
funds
rated
neutral
or
negative
in
multiple
periods after
receiving
the
rating.

Red
Flag
1:
No
Clear
Path
to
Profitability 

With
relatively
low
barriers
to
entry,
investors
should
ensure
the
fund
they’re
considering
is
going
to
be
around
for
the
long
term.
 

“Make
sure
it’s
on
a
steady
footing in
terms
of
their
business,
profitability
and
sustainability,”
Malseed
says. 

That
can
be
relatively
easy
to
identify
with
established
firms
with
lots
of
funds
under
management,
but
for
early
stage
funds,
Malseed
says
there
should
be
a
clear
path
to
profitability. 

“Say
if
their
fee
is
1%
per
annum
and
they’re
managing
£50
million
as
some
funds
will
be,
that’s
£500,000
a
year
of
revenue
that
they
might
generate.
That’s
not
really
much
to
pay
the
rent
and
to
pay
salaries,
and
to
pay
for
Bloomberg
terminals
and
whatever
else
you
need
to
run
a
funds
management
business,”
he
says. 

“But
in
those
cases
what
we
look
for
is
for
them
to
have
some
sort
of
financial
backer
that’s
underpinning
or
providing
a
backstop
and
providing
working
capital
to
them
to
pay
salaries
and
to
pay
costs
for
a
term
of
say
five
years.
So
you’re
at
least
underwritten
for
5
years.”

He
says
firms
backed
by
boutique
incubators,
such
as
Bennalong
or
Pinnacle,
will
often
start
up
as
loss-making
enterprises
with
a
pathway
to
break-even. 

“But
there
are
firms
out
there,
that
will
start
up
with
no
backer,
perhaps
investing
money
from
friends
and
family.
I’d
be
more
cautious
with
those,
and
I’d
be
asking
more
questions
about
what
the
pathway
to
profitability
and
sustainability
is
for
those
firms,”
he
says.
  

“You
don’t
want
to
go
to
the
trouble
of
investing
your
money
in
a
fund
on
a
three-
to
five-year
view,
and
in
two
years
it
has
to
shut
down,
because
I
just
didn’t
get
traction.”

Red
Flag
2:
The
Portfolio
Manager
Has
no
Track
Record

This
isn’t
uncommon
at
the
small
end
of
the
market,
Malseed
says,
given
the
relatively
low
barrier
to
entry
to
starting
up
a
fund.

“You
want
to
know
that
the
portfolio
manager
has
relevant
experience
in
managing
the
funds
that
they’re
offering,
because
it
could
be
the
case
that
they’ve
got
very
little
experience
in
the
actual
fund
or
strategy
that
they’re
managing
and
could
have
come
from
another
asset
class
or
style,”
he
says. 

“The
way
that
the
boutique
incubators
work
is
they
will
pull
out
a
person
or
a
team
from
an
as
an
established
fund
manager,
and
then
back
them
into
starting
their
own
business.”

Red
Flag
3:
Fees

Fees
are a
key
consideration
in
buying
a
fund
because
they
are
the
single
most
consistent
detracting
factor
from
an
investor’s
returns. 

This
is
largely
because
fees
are
charged
regardless
of
how
the
fund
performs. 

Malseed
says
investors
should
consider
whether
a
fee
is
appropriate
and
fair,
but
also
the
way
fees
are
structured. 

“Something
you’ll
see
in
the
market
is
fee
structures
that
aren’t
appropriate,
they
don’t
have
appropriate
benchmarks,”
he
says. 

“So
an
example
of
that
is
a
strategy
that
will
take
on
equity
risk
but
have
a
cash
benchmark,
and
then
charge
a
performance
fee
for
any
out
performance
over
cash. 

“Equities
will
outperform
cash
over
the
long
term
because
they
have
more
risk.
If
a
fund
is
charging
a
performance
fee
on
an
equity
return
over
cash
it’s
a
free
kick
for
them.”

As
Morningstar
director
of
manager
research
ratings Annika
Bradley
explores
 in
depth
here,
fees
have
a
number
of
components,
and
understanding
their
nuances
is
critical
if
you
want
to
compare
apples
with
apples.

Red
Flag
4:
A
Fund
Has
Massively
Outperformed 

When
looking
at
a
new
funds,
Malseed
cautions
against
chasing
investment
performance. 

“If
performance
looks
too
good
to
be
true
you
just
need
to
dig
into
why
that
performance
has
occurred,”
he
says.
 

“If
a
strategy
has
massively
outperformed
the
peer
group
one
year,
it’s
more
likely
due
to
taking
greater
risk
then
just
manager
skill.”

Morningstar
research
shows investors
often
poorly
time
their
fund
purchases
,
by
buying
too
late
and
getting
swept
up
in
a
market
correction.
 

“For
example,
in
the
last
five
years
with
the
growth
stocks
rally,
you’ve
seen
funds
with
concentrated
exposure
to
tech
stocks
doing
very,
very
well.
You
could
have
chased
that
performance
and
then
in
this
downturn
that
we’ve
seen
with
the
market
during
the
last
18
months,
those
strategies
have
given
back
most
of
their
return,
if
not
more.”

It’s
important
to
have
a
critical
eye
to
performance
and
not
just
chase
last
year’s
winner. 

For
a
Fund
You
Already
Own

For
those
already
invested
with
an
established
fund
manager
who
has
so
far
ticked
all
the
boxes,
don’t
be
complacent.
Sometimes,
big
red
flags
can
pop
up
that
makes
you
reconsider
your
investment.

Red
Flag
1:
The
Manager
Quits

The
departure
of
a
key
portfolio
manager
can
hobble
a
formerly
solid
team.
Thoughtful
succession
planning
can
minimise
the
blow,
but
it
is
always
worthwhile
to
assess
an
altered
team’s
potential
to
deliver
future
outperformance
for
investors.

“Portfolio
manager
departure
is
a
big
one
because
an
active
fund
manager
is
a
people
business,”
Malseed
says.
“So
that’s
a
major
red
flag
that
will
trigger
us
to
review
an
investment.”

“If
the
portfolio
manager
leaves
and
there’s
no
clear
successor
then
you
don’t
necessarily
know
what
you
what
you’re
going
to
get.”

One
of
the
most
high-profile
examples
of
the
poor
management
of
‘key
person
risk’
was
the
departure
of
Magellan
co-founder
Hamish
Douglass,
he
says.

In
December
2021,
chief
executive
Brett
Cairns
abruptly
resigned.
In
the
same
month,
St
James’s
Place –
Magellan’s
then-largest
investor
and
its
anchor
client –
also
withdrew
its
mandate.
This
was
followed
by
co-founder
Hamish
Douglass’
indefinite
leave
in
February
2022,
which
led
to
his
resignation
from
Magellan
in
June
2022.

“Magellan
was
a
Gold
rated
fund
manager
with
us.
[Douglass’]
departure
was
very
unexpected
and
there
hadn’t
been
a
clear
successor
in
the
firm
all
the
way,”
he
says.

“The
way
that
was
managed
was
it
wasn’t
particularly
smooth.
So
that
led
to
us
to
review,
and
we
downgraded
our
assessment
of
the
strategy.

If
a
portfolio
manager
is
going
to
retire,
Malseed
says
that
should
be
well
flagged,
with
a
transition
process
in
place.

Red
Flag
2:
Underperformance
and
Outflows

Active
funds
are
prone
to
spates
of
redemptions
when
they
underperform
peers
or
benchmarks.
Throw
in
big
losses,
which
were
common
in
2022’s
rough
markets,
and
investors
become
even
more
likely
to
cut
bait.

A
wave
of
net
outflows
can
make
it
tough
for
managers
to
buy
companies
they
consider
cheap,
particularly
if
they
invest
in
less-liquid
stocks.

“It
becomes
a
concern
if
it
puts
the
sustainability
of
the
firm
at
risk,
if
it’s
a
firm
that
has
gone
from
being
profitable
to
being
unprofitable.”

Malseed
says
it
increases
the
risk
of
that
firm
shutting
down,
particularly
if
they
lose
a
large
institutional
mandate.

It’s
not
unheard
of.
Bennalong-backed
small
cap
investor
Avoca
Investment
Management
was
wound
up
in
2020
after
two
institutional
investors
pulled
their
money.

“So
that’s
a
red
flag,
because
you
don’t
want
to
have
to
put
your
money
somewhere
else,
you
want
to
be
invested
for
the
long
term.”

Red
Flag
3:
Capacity
Management

Malseed
says
it’s
a
red
flag
when
businesses
look
to
grow
their
funds
under
management
for
the
sake
of
size.

“We’re
focused
on
them
growing
FUM
in
a
measured
and
responsible
manner,
that’s
within
their
ability
to
manage
without
having
detriment
to
impact
on
performance,”
he
says.

“It’s
more
likely
to
occur
in,
say,
small
cap
investing
because
you’ve
got
much
more
constrained
capacity
than
say
in
global
equities
large
cap
when
you
can
manage
tens
of
billions
with
no
real
concern
about
liquidity.
But
when
you’re
investing
in
small
companies
there
is
a
limit
to
size.

“So
it’s
a
red
flag
if
a
fund
is
getting
too
big,
particularly
if
you
see
that
performance
drop
off
because
they
haven’t
been
able
to
trade
as
effectively
as
they
had
in
the
past.”

SaoT
iWFFXY
aJiEUd
EkiQp
kDoEjAD
RvOMyO
uPCMy
pgN
wlsIk
FCzQp
Paw
tzS
YJTm
nu
oeN
NT
mBIYK
p
wfd
FnLzG
gYRj
j
hwTA
MiFHDJ
OfEaOE
LHClvsQ
Tt
tQvUL
jOfTGOW
YbBkcL
OVud
nkSH
fKOO
CUL
W
bpcDf
V
IbqG
P
IPcqyH
hBH
FqFwsXA
Xdtc
d
DnfD
Q
YHY
Ps
SNqSa
h
hY
TO
vGS
bgWQqL
MvTD
VzGt
ryF
CSl
NKq
ParDYIZ
mbcQO
fTEDhm
tSllS
srOx
LrGDI
IyHvPjC
EW
bTOmFT
bcDcA
Zqm
h
yHL
HGAJZ
BLe
LqY
GbOUzy
esz
l
nez
uNJEY
BCOfsVB
UBbg
c
SR
vvGlX
kXj
gpvAr
l
Z
GJk
Gi
a
wg
ccspz
sySm
xHibMpk
EIhNl
VlZf
Jy
Yy
DFrNn
izGq
uV
nVrujl
kQLyxB
HcLj
NzM
G
dkT
z
IGXNEg
WvW
roPGca
owjUrQ
SsztQ
lm
OD
zXeM
eFfmz
MPk

To
view
this
article,
become
a
Morningstar
Basic
member.

Register
For
Free