With thousands of managed funds available in Australia, the Morningstar fund ratings serve as an aid for investors who want to avoid underperforming active fund managers.

Financial advisers are also opting for exchange-traded funds (ETFs) to avoid the underperformers.

Tim Murphy, director of manager research at Morningstar Australia, says his team rates more than 3500 Australian actively managed funds and classifies those funds into five different rating categories: Gold, Silver, Bronze, Neutral and Negative.

If a managed fund receives a positive rating of Gold, Silver, or Bronze, it means Morningstar analysts think highly of the fund and expect it to outperform over a full market cycle of at least five years.

"We cover the vast majority of the large and most widely available investment funds in the market, which adds up to thousands," says Murphy.

"Our fund ratings take into account the competitive advantage of the fund in terms of the investment team and its process. We look at the fees of the fund and, as a final step, the past performance of the fund.

"That is very beneficial to self-directed investors who don't have the skills to do that analysis themselves."

Avoiding underperforming fund managers is no easy task, given that most underperform their respective benchmarks over the short and long term, according to the S&P Dow Jones Indices SPIVA Australia Scorecard.

In the 12-month period ending 30 June 2017, most Australian funds in most categories underperformed their respective benchmarks, apart from the Australian A-REIT category, according to the SPIVA Scorecard.

Over the 10-year period ending 30 June 2017, more than 85 per cent of international equity and Australian bond funds and more than 70 per cent of Australian general equity and A-REIT funds underperformed their respective benchmarks on an absolute basis.

However, only 36.8 per cent of Australian small-cap funds lagged their benchmarks. "Fund managers are more able to add value with small caps through company selection as it's an under-researched part of the market and there isn't a lot of analysis out there. With large caps, it varies from year to year," says Murphy.

For this reason, independent financial planner Bruce Brammall largely avoids using active fund managers and instead opts for ETFs, which aim to track an index, rather than beat it.

"If you take 10 active fund managers and one index fund, the index fund is likely to do better than the average of the other 10 actively managed funds," says Brammall.

"I saw the disaster that occurred in the GFC, that is, highly paid fund managers who charge high fees got crunched.

"I don't know too many active fund managers who can consistently beat their benchmarks, so I've always taken the approach of using index funds, which charge tiny fees, rather than using active fund managers. With an index fund, you know what you are going to get, that is, a fund that performs in line with the market.

"So instead of paying management fees ranging from 0.7 per cent to 1.5 per cent, on average our clients would pay fees averaging around 0.22 per cent. Occasionally we use active fund managers because a client wants a specific exposure, such as socially responsible investing."

For those investors seeking an active fund that could outperform the market, Morningstar's five-step process for rating managed funds is designed to identify funds that are more likely to outperform over the long term on a risk-adjusted basis.

Morningstar analysts assign a rating of Positive, Neutral, or Negative to each pillar after examining each of the following questions.

• Process: What is the fund's strategy and does management have a competitive advantage enabling it to execute the process well and consistently over time?

• Performance: Is the fund's performance pattern logical given its process? Has the fund earned its keep with strong risk-adjusted returns over relevant time periods?

• People: What is Morningstar's assessment of the manager's talent, tenure, and resources?

• Parent: What priorities prevail at the firm? Stewardship or salesmanship?

• Price: Is the fund a good value proposition compared with similar funds sold through similar channels?

A Gold Morningstar Analyst Rating reflects a "best-of-breed fund that distinguishes itself across the five pillars and has garnered the analysts' highest level of conviction".

A Silver rating goes to a "fund with advantages that outweigh the disadvantages across the five pillars and with sufficient level of analyst conviction to warrant a positive rating".

A Bronze rating goes to a "fund with notable advantages across several, but perhaps not all, of the five pillars--strengths that give the analysts a high level of conviction".

A Neutral fund isn't likely to deliver standout returns but also isn't likely to significantly underperform.

A Negative fund has at least one flaw likely to significantly hamper future performance and is considered by analysts to be an inferior offering compared to its peers.

More from Morningstar

• The Amazon eagle has landed

• Can Telstra be a global technology giant?

• Make better investment decisions with Morningstar Premium | Free 4-week trial

 

Nicki Bourlioufas is a Morningstar contributor. This is a financial news article to be used for non-commercial purposes and is not intended to provide financial advice of any kind. Opinions expressed herein are subject to change without notice and may differ or be contrary to the opinions or recommendations of Morningstar as a result of using different assumptions and criteria.

© 2017 Morningstar, Inc. All rights reserved. Neither Morningstar, its affiliates, nor the content providers guarantee the data or content contained herein to be accurate, complete or timely nor will they have any liability for its use or distribution. This information is to be used for personal, non-commercial purposes only. No reproduction is permitted without the prior written consent of Morningstar. Any general advice or 'class service' have been prepared by Morningstar Australasia Pty Ltd (ABN: 95 090 665 544, AFSL: 240892), or its Authorised Representatives, and/or Morningstar Research Ltd, subsidiaries of Morningstar, Inc, without reference to your objectives, financial situation or needs. Please refer to our Financial Services Guide (FSG) for more information at www.morningstar.com.au/s/fsg.pdf. Our publications, ratings and products should be viewed as an additional investment resource, not as your sole source of information. Past performance does not necessarily indicate a financial product's future performance. To obtain advice tailored to your situation, contact a licensed financial adviser. Some material is copyright and published under licence from ASX Operations Pty Ltd ACN 004 523 782 ("ASXO"). The article is current as at date of publication.