One of the many areas that the UK Financial Conduct Authority’s interim report on the asset management industry explored was fund ratings. The FCA claimed that products recommended by consultants did not perform better than non-recommended products.
A strong analyst assessment will often increase a fund’s assets under management. Indeed, the FCA found that assets were concentrated in funds with higher Morningstar star ratings.
Morningstar is one of the top fund raters and came in for particular scrutiny in the regulatory market study.
The regulator questioned the value of ratings after finding that funds awarded Morningstar’s highest ‘five star’ award did not tend to outperform their benchmarks net of charges.
Returns were “statistically indistinguishable from zero” after fees were taken out, the regulator said, and neither did funds awarded a gold, silver or bronze analyst medal from Morningstar outperform their benchmarks net of charges; again net-of-fees excess returns were essentially nought.
Moreover, the FCA concluded Morningstar’s methodology effectively penalised passive investment vehicles, as it makes no distinction between passive and active funds when evaluating a product. The FCA found tracker funds were likely to be assigned an average rating, with only a minority receiving a high rating. This, the FCA said, produced an over-allocation of assets into active share classes at the expense of index-tracker products.
Five-star rated funds were found to perform better on average than non-five-star rated funds, although the report is quick to acknowledge such analysis does not directly address the question of whether investors who chose only five-star rated products would achieve higher returns than if they had chosen tracker funds. An investigation of this topic will be included in the FCA’s final report next year.
There were even suggestions of fund ratings being driven by commercial interests. While asset managers do not pay to have their investment products analysed by Morningstar, investment houses do pay a fee to use the rating in their marketing material.
“Some argue that asset managers will not pay to use a bad rating, which incentivises rating companies to give funds positive scores to generate business…passive funds are less likely to pay to use ratings,” the report said.
Rory Maguire, managing director of investment advisory Fundhouse, welcomed the findings and said there has previously been no accountability for ratings firms, and no public record of whether funds ratings actually add value.
“Ratings firms sell fund managers rating logos for their marketing and sales efforts. Raters claim the team doing the research have no idea which fund managers are clients, so there’s a Chinese wall,” he told Funds Europe.
“We think Chinese walls are porous. Imagine giving a manager a negative rating, if they are contributing to your salaries and rent.”
He added that most active managers don’t outperform, “yet 95% of ratings are positive” and claimed ratings are “all so rosy” to protect relationships with fund manager clients.
Laith Khalaf, senior analyst at Hargreaves Lansdown, declined to comment on the FCA’s findings – but defended the principle of fund ratings.
“With thousands of funds to choose from, fund ratings can be a vital shortcut for investors – there’s no other way of trimming that investment universe down,” he said.
“Obviously, investors need to make sure the ratings are trustworthy, and a ratings provider can demonstrate their ratings have merit – that their recommended funds have more often than not outperformed.”
Jonathan Miller, director of manager research at Morningstar, told Funds Europe that there were differences between the FCA’s methodology and the firm’s own.
Morningstar’s performance analysis, he said, showed material outperformance for positively rated funds versus the standard benchmark the firm assigns to each Morningstar category, assuming three to five-year holding periods subsequent to the date ratings were assigned.
On the issues raised around index funds and ETFs, Miller said if passive vehicles outperformed their category peers on a risk-adjusted basis, their ratings would automatically reflect that – and there is no analyst intervention in the calculation of star ratings.
©2016 funds europe
