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Keen-eyed investors will have noticed a common footnote on all their mutual fund and ETF performance statements: “Performance quoted represents past performance and does not guarantee future results” (or something similar). Although potentially viewed as a statement of the obvious, it also prompts the question – what should investors consider when selecting their investments for the future if past performance is not guaranteed?

Very few things can be guaranteed, but applying a robust forward-looking approach to analyzing your mutual funds and ETFs can help make more informed decisions. Morningstar’s fund analysts rely on a framework whereby funds are analyzed using five pillars: people, process, parent, performance and price. Combined, these pillars help paint a picture of funds to better understand their behaviours on a go-forward basis. I like to describe this as understanding the “personality” of a fund.

So, what does an assessment of each of these pillars entail? Let’s take a look:

People: When considering how a fund behaves, the first place to look is at who is making the decisions. This means looking at the portfolio managers, analyst teams, trading teams, etc. Best practices suggest that a diverse team of individuals – whether that be diverse educational professional backgrounds, ethnic, race or gender backgrounds – perform better and more consistently. Groups that have been together for longer can also lead to more predictable outcomes and execution of a mandate.

Process: A strong investment process – which includes the research, portfolio construction and risk management approaches used by the investment team – is well-defined and consistently executed. It is generally able to withstand short-term market volatility shocks and rewards investors over the long term. A common misconception is that a strong process will result in outperformance all the time. That is not necessarily the case. A strong process will however perform consistently in similar markets. For example, an investment process focused on high-quality companies may perform well when markets are weak but might struggle when markets are rising due to the inherent defensive characteristics of these types of companies.

Parent: An assessment of a fund’s parent, also known as the asset manager, is an attempt to understand the resources which the people and process can leverage. How a firm operates and the way in which decisions are made can affect areas such as risk management, recruitment and retention of key personnel, investment professional compensation and pricing schemes. Weaknesses and strengths in these areas can affect the longevity of a fund. Hence, it is best to invest with companies where your objectives as an investor are among the firm’s top priorities.

Performance: Although past performance cannot be guaranteed in the future, analysis of performance trends can help shed light on whether the team and process have been consistent. For example, if a fund is labelled a growth-style fund and has underperformed in markets when growth-style investments are outperforming, the efficacy of the execution of the strategy would be questioned.

Price: Morningstar research has shown that price can be the single strongest indicator of a fund’s success over the long term. In Canada, investors can pay different fees based on whether the purchase is commission-based funds (where the cost of advice is embedded in the price of the fund), fee-based funds (where the cost of advice is charged on top of the cost of the fund, usually known as an adviser fee) or do-it-yourself funds (where there is no advice provided and no commissions or fees). In many cases, the cost of ETFs is much lower than for traditional mutual funds, which has been a significant driver of their popularity.

These pillars drive our forward-looking ratings for fund and ETFs. Our history shows that on aggregate, funds that are well-rated using this methodology end up outperforming those that were poorly rated in periods after receiving a rating.

Forward-looking mutual fund and ETF analysis can be complex, but worth considering when making long-term investment decisions. Investors looking for some help with that can consult Morningstar’s resources, where we will be launching an enhancement to our forward-looking ratings May 2. These tools combine the best of Morningstar’s analyst and quantitatively driven tools to help empower investors’ decisions.

Danielle LeClair, MFin, is director of manager research, Canada for Morningstar Research Inc.

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