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Fund Ratings: who rates us?

Published: April 8, 2014 by Rory Maguire, Fundhouse UK
fwd_magazineicon Fundhouse has been qualitatively evaluating and rating asset managers for institutional clients for many years, although only fairly recently for financial advisers and platforms. In this article we discuss specialist fund research and touch on some fundamentals that we think are essential to evaluating fund managers effectively.We break research down into two broad principles that should underpin and direct what we do. The first is behavioural – we are here, ultimately, to enable advisers to better serve the needs of the end client and savers, before serving ourselves. A stewardship mindset. And secondly, our opinions and ratings should be supported by sound evidence. Notably, though, the latter is far less effective without the former.
Why is the appropriate mindset important? Having a stewardship belief system centres us behaviourally. At its heart, it makes us inwardly sceptical and sets up some protections, mostly from ourselves. It makes us ask important questions, such as, are fund ratings businesses likely to add any real value? It’s only fair, if we are sceptical of an asset manager’s ability to add value, shouldn’t we also be willing to turn that mirror on ourselves? We should, particularly if active managers have low success rates, as we could be locked into a worse one because of the interrelatedness of their success and our ability to spot it.

 

“Fund ratings, good or bad, have the opportunity to enable and influence future outcomes – particularly the well-considered, critical ones.”

This mindset is all very healthy for the end client. We can use a basic hypothetical example to show why. If we assume 45 out of 100 global equity funds are likely to beat the market over time and after fees, what are the odds of us finding the 45? If we were exceptional, let’s say with a 70% hit rate, our odds would be 70% of 45, or 31.5%. Poor odds, even with a flattering hit rate. Should we be satisfied with this departure point and believe we are so exceptional that we “just back ourselves”? Or is modesty called for because of what behavioural psychologists say is more likely – “people tend to be overly optimistic about their relative standing in any activity in which they do moderately well.” [1]

If we believe we are fallible (which we do), the table below offers some insurance.  Clearly, if we want to set the correct baseline for the odds, to shift them from 31.5% to 70%, we need to issue a substantial, representative number of negative ratings.  An obvious point, maybe, but negative ratings are really rare. Perhaps that’s because issuing meaningful numbers of negative fund ratings isn’t easy, even if it would be statistically expected. Rating fund managers positively is far more comfortable because the relationship with the managers remains a very friendly one and access to them is a business imperative. Furthermore, the managers may be keen to buy marketing rights for all the positive ratings – negative ratings don’t sell! So, being generous with ratings is all very positively reinforcing, for revenue and relationships alike.

But what if we circle back to the end client? This sanguineness wouldn’t extend to the end savers and advisers relying on the reports if the bulk of the ratings they subscribed to were not representative of probable fund manager success rates. So, by shifting our perspective from ourselves to the end clients, we only have one real choice – to issue and publish negative ratings where warranted (and ours are material in number).

At this point you may ask, does at times, being critical contribute towards a constructive client experience? Don’t clients only want the names of the winners? While we publish many positive ratings, we do believe that our critical ratings also add positive value. This is largely because of the obvious, but often overlooked point that clients invest prospectively, not retrospectively. Therefore fund ratings, good or bad, have the opportunity to enable and influence future outcomes – particularly the well-considered, critical ones.

“Our hope is that, by offering some criticism of this sort of outcome today, that we encourage better portfolio manager succession tomorrow”

Maybe an example will tie it all together. We all know investment teams and portfolio managers move around. But, what seems to coincide is that such changes are abrupt, particularly when the manager is a ‘star’. If we bring a stewardship mindset to this aspect, we start to wonder more about the clients who remain behind, ahead of the portfolio manager who left. We want to be sure, regardless of how good the manager is, that they deeply considered their

succession (and therefore the client) before moving to greener pastures. Our hope is that, by offering some criticism of this sort of outcome today, we encourage better portfolio manager succession tomorrow. We would also look at the evidence behind portfolio manager changes. For example, there is quite a lot of evidence to suggest that star managers struggle in new environments. “Odds are, the superstars you eagerly and expensively recruit will shine much less brightly for you than for their previous employers. Research shows why — and why you’re usually better off growing stars than buying them.” [2] So, when we bind this all together, we find ourselves drawn towards client-oriented criticism and evidence-driven opinions.

So to conclude, by getting our bearings from what an end saver would expect and would ask, we find we may dramatically adjust how we evaluate fund managers and judge ourselves. We would also address our research slightly differently if we ask, what thought was given to the client by the fund manager when creating a process or making a change? An adviser once asked us, “Who rates the rater?” The answer is – nobody.



1. From Daniel Khaneman’s book, Thinking Fast and Slow, 2011
2. The Risky Business of Hiring Stars by Boris Groysberg, Ashish Nanda, and Nitin Nohria, Harvard Business Review, May 2004