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Does Your Mutual Fund Have a Competitive Edge?

Four traits that can separate advantaged funds from disadvantaged funds.

It's championship time for the NBA and NHL, and sports fans are arguing over which of the remaining teams in each sport have that certain something that will put them over the top. Basketball's Los Angeles Lakers have a bona fide future Hall of Famer on their side--a definite competitive advantage--but the Boston Celtics arguably have three potential inductees. The Chicago Blackhawks, who are leading the Stanley Cup Finals against the Philadelphia Flyers, have lots of young talent, including a defenseman who chews slap shots and spits teeth, which on a hockey rink is a desirable trait. Meanwhile the Flyers have a knack for coming back when everyone writes them off.

A mutual fund doesn't have to hit fade-away jumpers with the shot clock expiring or sacrifice its incisors to save a goal. Yet, it's important to ask if a fund has a competitive advantage before investing. Just as Morningstar stock analysts focus on understanding whether a company has an economic moat that keeps rivals at bay, Morningstar fund analysts spend a lot of time figuring out whether a fund has a sustainable edge over its competition. In the spirit of this championship season, here are some enduring advantages with which a mutual fund can be endowed. It's not an exhaustive list and there could be some overlap between them, but finding a fund with a combination of these traits could lead you to a winner.

More for Less
Low cost is the simplest advantage. The less you pay up front, the more return you get over the long run. A quick screen in Morningstar's database shows that fixed-income funds, domestic-stock funds, and international-stock funds with below-average expenses have higher one-, three-, five-, and 10-year rankings in their respective categories. Numerous more detailed studies by Morningstar and others have shown low expenses to have a higher correlation with future returns than other factors, such as past performance, turnover, and risk. Yes, there are some funds with above-average fees that buck the trend, but there are far more high-cost funds that peter out and die. In general, investors increase the odds of getting more return for their money by paying less.

The Cheap Shall Inherit the Flows

 Expense Ratios at least 20% less than Broad Group Avg.Expense Ratios +/- 20% of Broad Group Avg.Expense Ratios at least 20% greater than Broad Group Avg.5-Year Flows Totals1,304.1216.9-6110-Year Flows Totals2,111.4488.5-10.8

 

Fund companies also increase their odds of success as businesses by keeping expenses low. Recent studies have shown investors are voting with their dollars and moving to low-cost funds, which have gotten more inflows than their exorbitant counterparts over the past decade. That can create a virtuous circle in which low fees help returns, which attracts assets, which leads to economies of scale that lower fees and help performance, as long as the bigger asset base doesn't overwhelm the managers. The fees of Vanguard and American Funds are hard to beat in their respective no-load and load marketplaces. The bond funds from Dodge & Cox, Bridgeway, Schwab Funds, TIAA-CREF, Dimensional Fund Advisors, and Baird also offer significant cost advantages.

In the Market, But Not of the Market
Cost are only one part of the picture, albeit a very important part. Funds need to prove they can add value. There are a lot of managers out there striving for the same thing--investment outperformance--and, trust me, most of them aren't doing anything special. Competition is keen, whether a manager is looking for the next hot growth stock, overlooked value opportunity, or top-down theme. That's why, when opting for active management, it's vitally important to choose a fund with a sound and difficult-to-replicate strategy. A fund can have a unique approach, like an algorithm or a manner of gathering information that hasn't been tried before; but if it is easy for others to recreate, the fund's days of outperformance are numbered.

Truly advantaged approaches are built over years, generations even. Mutual Series' hard-to-acquire expertise with distressed debt and other deep-value specialties started with founder Max Heine and value-investing legend Michael Price. It was passed to former CIO David Winters, who now runs Wintergreen Fund. It is currently preserved by CEO Peter Langerman and his team.

A thorough knowledge of and experience with a particular sector has given  Vanguard Health Care's (VGHCX) Ed Owens and  BlackRock Energy & Resources(SSGRX) Dan Rice perspective few others possess.

Maintaining a strict discipline also can distinguish a fund. Few funds are more disciplined than  Jensen Fund (JENSX), which doesn't even look at a stock until it has posted returns on equity of 15% or more for 10 consecutive years. That allows the fund's managers to focus on understanding and valuing a small number of companies they can hold with confidence for the long term.

 

If You Build It �
Vanguard's funds are consistently among the cheapest in their categories because the firm's corporate structure demands it. Vanguard's funds, and by extension its fundowners, own the company. That compels it to offer services, such as administration, marketing, and management, at cost. That eliminates a lot of conflicts of interests faced by for-profit fund companies, both public and private. The family is less likely to put the interests of its owners ahead of that of its clients because the clients are the owners. The mutual ownership structure doesn't make Vanguard perfect, but it makes it harder for the family to misbehave by, for example, keeping hot funds open when they're deluged by new money, launching a lot of trendy funds, or advertising short-term performance.

Vanguard founder Jack Bogle often bemoans the fact that his former firm remains the only mutually owned fund family. But other structures need not be disadvantaged. Privately held boutiques must balance profits with professionalism, too. Recent experience, however, shows firms largely owned by active investment personnel are less likely to be swayed by short-term considerations.

The 2007-09 financial crisis forced lots of hasty decisions. Numerous firms laid off investment personnel, including the publicly traded  AllianceBernstein (AB), which fired one of the most experienced value investors in the business, former CEO Lew Sanders, near the bear market's nadir. Investors in other fund families with publicly traded owners wound up with fundamentally altered funds.  Bank of America (BAC) sold Columbia to  Ameriprise Financial (AMP) and Evergreen became part of  Wells Fargo (WFC) with the rest of Wachovia, triggering waves of fund mergers and liquidations.

Meanwhile, several owner-operated firms, such as Dodge & Cox and Davis Advisors, managed to stay independent and attract new talent during the downturn even though they suffered bouts of severe underperformance and outflows. Because they controlled their own destinies, they were able to hunker down and stay focused on the long term.

Culture Counts
Culture is hard to measure empirically, but very important. Structure can provide incentives to act in shareholder's interests, operate honestly, and think long-term, but it can't guarantee a fund will do so. That's why an investor-oriented corporate culture is so significant. It's the secret sauce that ensures a fund or fund family will take advantage of all its other advantages, such as structure, low fees, and differentiated investment process.

Morningstar assesses fund-family culture by observing behavior and asking a few simple questions. For example, whom would you trust: A firm, in the pursuit of more fee-generating assets, launching and relentlessly advertising fund after fund in whatever niche happens to be hot, or a family with just a handful of funds launched over decades, based on a tried and true investment strategy, and sold quietly without much mention of short-term performance? In our view, the latter are more trustworthy. The list includes some firms already mentioned, and others, including Longleaf Partners and  T. Rowe Price (TROW).

Just like arguments between Lakers and Celtics fans, or between Blackhawks and Flyers fans, a discussion of competitive advantages in investing could go on and on. What do you think gives a fund the drop on its peers?

Dan Culloton has a position in the following securities mentioned above: VGHCX. Find out about Morningstar’s editorial policies.