Metal detectors: How to make sense of fund ratings

Rob Gleeson, investment product consultant at FE, explains all you need to know about the many and varied fund rating systems in the market.

The number of funds advisers have to choose from has increased dramatically in the past few years. The increased popularity of open architecture platforms and the growing number of European-domiciled funds available for sale in the UK has combined to create a truly baffling number of potential investment choices.

With RDR increasing pressures on advisers to minimise costs and increase efficiency, few will be able to devote the time to research every option. Anyone looking for an edge should be using ratings as a metal detector to help them find the potential needles in the haystack.

There are, however, almost as many choices of ratings as there are funds: stars, crowns, As and medals to name but a few. Investors need to understand exactly what these ratings do and, importantly, what they do not do.

Ratings explained

There are two types of rating: quantitative ratings based on performance data, and qualitative ratings based on analyst opinions. Both types have the same objective – to identify funds that have a good chance of future outperformance – but there are important differences in their approaches.

Qualitative ratings rely on an analyst talking to the fund manager and studying his performance and strategy. They tend to look at all the elements that influence performance, such as the manager’s experience, the resources at their disposal, how their strategy has done in the past, and importantly, how they might behave in the future.

The rating is based on the analyst’s careful consideration and judgement. Either they think everything is in place for the fund to do well, or there are fundamental weaknesses, or something in between and the fund is rated accordingly.

This is a good approach, and intuitively makes a lot of sense. Invesco Perpetual’s flagship High Income fund retained its top qualitative ratings despite 18 months of below average performance, whereas under quantitative systems its ratings started to slip. The fund subsequently recovered and has had an outstanding six months.

However, there are also drawbacks – the biggest of which has always been the potential conflict of interest inherent in most qualitative ratings business models.

Funds have to pay the ratings agency to come in and rate their funds. This can be expensive, and thus, understandably, it does not make good business sense if you are going to receive a bad rating.