Listen on:

Shani Jayamanne: Welcome to another episode of Investing Compass. Before we begin, a quick note that the information contained in this podcast is general in nature. It does not take into consideration your personal situation, circumstances or needs.

Mark LaMonica: Today we've got another guest episode and it's with Steve Le from our manager research team.

Jayamanne: And Steve has been a Morningstar staff for quite a few years in various roles, but has been an analyst in our team that researches funds, ETFs, so that's exchange traded funds and LICs, all listed investment companies for about two and a half years.

LaMonica: And you might have seen Steve if you came to our conference last year, so in 2022, he did an ETF elevator pitch and spoke about getting multi-asset exposure, so basically just creating a portfolio in OneTrade.

Jayamanne: And what we're going to focus on today is what to look out for when investing in ETFs.

LaMonica: And everyone does love ETFs, so this should be popular, but we're also going to talk about what we don't want when we invest in ETFs.

Jayamanne: But we start with getting some insider tips on how to take the Morningstar research process and apply it as an individual investor. Morningstar's analysts do get access to portfolio managers, analyst teams, boards and the C-suite. They're able to form a deep understanding of the people running the funds and the companies that these investment products belong to.

LaMonica: And Steve goes through how individual investors can do this in their own research process and the three pillars of the Morningstar process. We also go through some examples of what not to look for in a fund.

Jayamanne: And lastly, we speak about choice. The increasing amount of choice in the market, where we've seen a range of ETF issuers competing for market share. They want your money to come into their ETF instead of their competitors. And what this has led to is duplicate ETFs in the market.

LaMonica: And that's basically just ETFs that are extremely similar, with little to no difference, covering popular benchmarks like the S&P 500 and the ASX 200. So we asked Steve how to differentiate between these ETFs and how investors should choose. And of course, what are the factors that they should look for.

Jayamanne: So really, this is a bit of a best of. And these are some of the most common questions that we get from listeners. So we're lucky to have Steve come onto the podcast to help us answer these questions.

LaMonica: All right. So as we mentioned, we do have a guest today. So we have Steve. Now, Steve, we're going to call you the reluctant podcast guest. So originally, we asked you to be on here and you made up this excuse of paternity leave. So apparently, you would rather take care of your son than come on this podcast.

Steve Le: I didn't realize that was such a crime.

LaMonica: Yeah. Well, that happened. Eventually, you said that you were back from paternity leave and then you skipped the podcast recording.

Le: Look, I'm here now and I think that's the most important thing and I'm happy to discuss anything you want.

LaMonica: Okay. Well, here we go. So we're going to grill Steve today. We're going to ask you a lot of questions. So first question that I think is easy is why don't you introduce yourself? I guess describe your background at Morningstar or any other background. You can talk about your childhood and how things in your childhood made you skip podcast recordings. But yeah, just take it away.

Le: So why don't I skip over my childhood? I don't want to bore the audience. But more relevant, I studied finance at uni and after that, I worked in various banking and broking jobs before joining Morningstar. Since I've been Morningstar for about six years now in total, half of that in the institutional product team and the other half in the research team.

LaMonica: Okay. And we're going to talk about the research team specifically today. So you are a member of our manager research team. So of course, you guys rate funds and ETFs and LICs, which is exciting. But we do have a methodology. And so, Shani and I talk about the methodology every once in a while. But I think it's better to actually hear from you about it. So basically, we have this pillar approach. So maybe if you want to talk about what are these pillars? So what are you looking at when you're going out and rating a fund or an ETF? And how should investors think about that?

Le: So as a manager research analyst, we assess funds based on three pillars that you mentioned. So I'll first start with the process and I'll assume that we're talking about an active investment strategy. And of course, we can touch on passive investment strategies later on. So in terms of a fund's process as an analyst, I look to understand the number of things. So first and foremost, the most important one is the fund's investment philosophy that underpins the strategy. And we're seeking to understand whether it has a competitive edge or not. And of course, we want funds that we are able to provide a risk adjusted return over a full market cycle that's greater than something we call the Morningstar Category Index. We of course seek to understand any risks associated with the fund's investment process as well. But I'll just quickly explain that a Morningstar Category is a peer group of funds that have a similar investment style. And we group those together for comparative purposes. And the Morningstar Category Index is the market index that we assign to that peer group. And we use that to benchmark the managers against.

So for example, an active Australian equity manager would be benchmarked against the ASX 200. Now that's the first pillar. The second pillar that we look at is called people. Now essentially what that is, is the relevant personnel and we assess them on a number of factors as well. And that includes their experience, their ability, as well as their workload. We also look at things like team structure and stability, as well as key person risk and succession planning. The last element is the people pillar. And some of the core areas of evaluation for the parent include the organizational structure and the business strategy, as well as the firm's culture and their investment culture. And we also do some basic analysis around cash flow and profitability. So those are the key areas that we look at.

LaMonica: Okay. So maybe if we can get back to process for a second. And I guess the question is, is there any way? Because obviously the fact that you work for Morningstar means that one of the things you do is you go and you meet with the managers. So the people who are actually making the decisions in these active funds, is there any way for an investor to assess that investment process if they are not you and they don't have, and obviously we'd encourage everyone to use Morningstar ratings, but is there any way to do that? Because so much that you get out of a fund manager is obviously sort of marketing spin before it actually comes out. Is there anything that someone can do?

Le: It's a good question and there's a couple of ways you can tackle this, but just before I get into that, I think the most important thing that I'll outline is we are one of the only independent research houses globally. And essentially what that means is we don't get paid to meet with fund managers and provide our view or a rating on those managers. So I'll just quickly make that point up front and I'm sure our audience is likely aware of that as well. But you know, if you're obviously not a Morningstar analyst, there's a couple of different ways you can approach this. So I'll point to industry conferences and events. Now there's plenty of those and throughout the day, there's a lot of free educational content that investors can learn about a fund manager and the way they invest. There's also plenty of free websites as well as podcasts such as this that will give investors access to free content.

And of course I believe our website as you mentioned Mark, gives investors free access to some data and information up to a certain point. I would also encourage people to speak to our financial advisors for any sort of complex investing matters. And one of the other areas that I would also encourage investors to do is go to their fund managers website and look through their materials such as like pdfs, their fact sheets, that will get investors to a good starting point. And also I would try getting in contact with the fund manager. Give them a call, get a sense of their attitude towards servicing direct or retail investors that will give you a good understanding of the fund manager's attitude towards servicing clients. Otherwise, pick up the phone, give us a call. I'm happy to answer any emails, chat to anyone. And yeah, happy to answer any questions from there.

LaMonica: Wow, so you volunteered. Well, you've done two things. You volunteered fund managers. So when you call the fund manager, say Steve Le from Morningstar told me to call you is the first thing. And then if anyone does have questions, you can email them to me since my email address is in there and I'll just pass them on to Steve. So now he basically has a second job. But what comes out of our ratings is what we call the medalist ratings. And we do spend a lot of time talking about, of course, the good ratings. So managers that get gold, silver, bronze, et cetera. We have a neutral rating, but then we also have a negative rating. And, a lot of life, I guess, is just trying to avoid things that are bad. So maybe talk a little bit about a negative rating. What would justify a negative rating?

Le: So I'll firstly say maybe don't drop my name. If you're going to give the fund manager a call because I could be unpopular, just given our independent rating model. So some fund managers might not be too happy with the way I rate them. But look, let me just quickly explain the Morningstar medalist rating of gold, silver, bronze, et cetera that you touched on, Mark, is of course the overall rating for a fund. Now, there are a number of reasons why a strategy could receive a negative rating under our research methodology. But one of the key drivers of the medalist rating is the rating of the three pillars that we just touched on earlier. Now, each pillar rating, so the people, the process, the parent, can receive a rating from one to five. So that essentially in qualitative terms means from high to low. So high, obviously being the highest conviction above average follows that, then average, and then so on. A simple way to think about it is the higher the pillar rating, the more positive the analyst view is on a forward-looking basis. And the lower the pillar rating would mean the analyst has lower conviction on that particular aspect of the strategy.

LaMonica: Okay. So that's like a really nice way of saying that we would sit there and say, we think you have a terrible process, terrible people. And yeah, we're not into your parents.

Le: Exactly.

LaMonica: I said it, of course, not you. But let's switch gears a little bit. And obviously, as you know, someone who follows the industry, a lot of particularly individual investors are gravitating towards ETFs. And while an ETF, of course, can be active, a lot of people are moving into more passive ETFs. And we, of course, use the same process, right? Whether it's a fund or an ETF, it's the same process. But what about passive? Because, in this case, how can you assess somebody's process when they're tracking an index?

Le: It's a really good question. Now, let me start by saying that our ratings methodology for passive strategies looks at the same three pillars. So people, process and parent once again. However, process is the key difference for passive strategies compared to active strategies. And that's because it carries a larger weight in our ratings methodology for passive strategies. And that's because passive strategies are ultimately trying to replicate the performance of a particular index, as you mentioned. Now, what we're looking for are indexes that are diversified and not concentrated, particularly from a sector perspective. We also want strategies that are able to track an index efficiently and as close as possible. And finally, we want organizations and teams that can implement those mentioned areas with a proven track record.

LaMonica: Yeah, I think, so I think there are two interesting points there. I'll sort of start with the one where I'll just say something and I mean, you can disagree if you want. But I do think investors in general, we've all decided that somehow like tracking an index, it could have thousands of different securities in there is easy. Like, oh, of course, they're just tracking the index. Well, that is hard. And obviously, there are these giant companies or that's BlackRock or Vanguard that have a lot of experience, but that still doesn't make it easy. So I think it's something people lose sight of. But really, the other point I wanted to make, I guess the question I wanted to ask is the interesting thing about sort of "passive" products now is they're tracking all sorts of different indexes. So there's obviously something like the S&P 500, you know, the ASX 200, that is a well-known established index. But now a lot of times people are basically making up indexes. And then they have an ETF tracking them. And they can be very, very different than those broad indexes. So maybe let's talk a little bit about that. And, whether we want to call that a factor ETF that's looking for like higher dividends or value shares, or like a thematic ETF that's tracking some sort of index that's supposed to capture this theme, how do you think about those? Or even an equal weighted index? I guess that's a good example as well. And something we've talked about a lot on this is an equal weighted index. Like how do you think about those? So you touched on it briefly, but I guess maybe just expand a little bit.

Le: Yeah, absolutely. So I'll start by saying that our ratings methodology classifies funds as either an active strategy or a passive strategy. So quite simple. Every fund is essentially assessed on those three pillars as we already touched on. And of course, the difference, as I mentioned, is the weighting of the process pillar for passive strategies. Now, to be specific, for a factor ETF or something like a dividend ETF, most of them fall under our passive ratings methodology because of their systematic nature. So again, what that means is process has a higher weighting for those types of strategies. Let's first start with a broad market ETF example. And I'll remind you one of the key things as an analyst that we're looking for here is how efficiently can this ETF or fund capture a particular opportunity set.

For example, the S&P 500 index is a commonly used benchmark that represents the largest 500 companies in North America. And we believe the iShares ETFs do a good job at replicating that index and it does so cheaply as well. The ticker codes for those ETFs are IHVV, that's the currency hedged version, and IVV for the unhedged currency version. Both ETFs have a Morningstar medalist list rating of silver with a high process pillar rating above average for people and above average for parents. So when it comes to something like a dividend ETF, a factor ETF or even an equal market weighted ETF, just remember we view most of them as a passive strategy. So they fall under that same methodology.

So I'll use a dividend ETF as an example. And the reason why I want to use a dividend ETF as an example is because I would advise some caution on these types of investment strategies for a number of reasons. So particularly from an Australian market perspective, we don't necessarily believe a dividend focus ETF is a good representation or an efficient way to capture the Australian opportunity set. So some of those ETFs are highly concentrated because they have a yield or an income mandate. And that can at times see them or at times lead to higher risk or volatility. And you can see that by looking at the historical return profile. Some of those ETFs also use backward looking metrics rather than forward looking ones to try to capture that yield or income. But anyways, nevertheless, we understand that some of these products may appeal to investors.

LaMonica: Everyone loves dividends.

Le: Everyone, particularly in Australia.

LaMonica: Including me. So that is a non-judgmental thing that I'm saying.

Le: And I can see why.

LaMonica: Because I'm so old.

Le: Maybe.

LaMonica: Is that what you're saying?

Le: It could be an age thing. It could be a Mark thing. I'm not too sure.

LaMonica: Okay, I'll take that.

Le: But nevertheless, look, if you're an investor, particularly in Australia, looking for an Australian dividend or income focus ETF, we do believe there are decent options in there. And one of them would be the iShares ASX Dividend Opportunities ESG Screened ETF. Look, that's a mouthful. But nonetheless, we think that's a reasonable option. And the ticker code for that one is IHD.

LaMonica: All right. Well, there is a recommendation for a dividend ETF.

Le: You know, let me jump in there. Sorry, Mark. I will say also, the reason why we think it's reasonable is because it's structure does somewhat address some of those pitfalls that I just mentioned. But of course, it would be sensible to pair this ETF with something that offers a bit more diversification.

LaMonica: One of the nice things that I like about ETF, even if they're not all that passive, is that of course, if they are tracking an index, you can go in and read the methodology, right? So it's a lot easier for an individual investor, despite your recommendation to call the manager and ask them what they're doing. You have no idea what the decision making process is, right? Like, you would probably uncover this during your research, but there could be a room full of monkeys throwing darts at a board, for all we know, right? As investors, especially because Australia has this ridiculous, let's not disclose holdings. But that's one of the reasons that and I do think that the documentation is pretty complicated sometimes, just for the average investor to read, but you can read through that methodology of why securities are picked, why they're not picked. So I do think that's helpful, but I will put a little plug in for you guys. If you read one of the reports on one of these sort of passive like ETFs, I think it is very clear and sort of the way you guys write about what number one the rules are, and then the implications on the portfolio. So there's my little plug for clear writing.

Le: Thanks for that. I appreciate that. I appreciate so on, I think it highlights the work we do.

LaMonica: Yeah, no, exactly. And this is after you didn't show up for two podcast recordings because of this paternity leave and then whatever else was going on. But one last question for you, and we'll let you get back to childcare. A lot of ETFs, particularly around some of these broad indexes, which I know that we favor, you will see competing product providers come up with basically the same ETF, right? So there are two different options to track. And I know we have that with like the ASX 200. And then if we add the ASX 300, which is pretty close, there's another one. How do you decide between or how would anyone decide between those two different products?

Le: It's a good question. And the first thing I'll point to are the fees, which is a decent starting point. And of course, the lower the fee, the less impact it has on compounded returns over the long term. But the key differentiators, of course, the quality of the business or the parent as we touched on, and the depth behind the offering in terms of the investment team implementing that process, which we also briefly touched on as well. Now, as we've mentioned, we view iShares or BlackRock as a good ETF provider. And we also view Vanguard and State Street as good providers as well. Now, all these firms have scale, they have depth of talent, proven track records, which is what we would like to see, as well as sophisticated systems and capabilities that should enable them to execute. Now, those are some of the key elements that we assess and look for when it comes to passive strategies. And of course, Mark, I guess you also touched on that retail investors obviously don't get the same level of access to these firms compared to a Morningstar analyst. And without making this a sales pitch, I would just encourage investors to read our research or subscribe to our website. And of course, as I mentioned at the start of the podcast, reach out to us if they have any questions, we'd be happy to answer any questions about a particular strategy or fund.

LaMonica: All right, we will see if you live to regret that offer to people. But anyway, we're going to stop here. But thank you very much. I think that, you know, we hear and we throw around terms so much like our medalist ratings and everything else. And it's good to spend a little time actually digging in and hearing about, I guess, hearing from the person who does it and then hearing about how that's done. So I appreciate you joining. I'm sure everyone else appreciates you joining. Anyone who wants to email Steve, just send it through to my email address that is in the show notes, and I will pass it along and we'll see if this is more of a responsibility than taking care of a newborn. So anyway, thank you very much, Steve.

Le: Thanks for having me.

LaMonica: And thank you, everyone, for listening. We, of course, would love emails that you have for me. You can send me questions as well. They don't just have to be for Steve. And also any ratings or comments in your podcast app. Thank you very much.

(Disclaimer: Any advice in this podcast is general advice or regulated financial advice under New Zealand law prepared by Morningstar Australasia Proprietary Limited and/or Morningstar Research Limited without reference to your financial objectives, situations or needs. You should consider the advice in light of these matters and any relevant product disclosure statement before making any decision to invest. To obtain advice for your own situation, contact a financial advisor.)