What is the best way to rate a fund?

Fund ratings can be an extremely useful tool for advisers. In addition to direct research and analysis of a fund, an external rating from an independent source can prove helpful in concluding whether a fund is best of breed – particularly in light of the FCA warnings that you cannot rely on managers’ risk ‘opinion’.

There are many ways to rate a fund. Morningstar uses its Analyst Ratings Scale to signify its conviction level for a particular fund, for example. It uses five “key pillars” that it considers critical to a fund’s ability to succeed – people, process, parent, performance and price – from which it will rate a fund as gold, silver, bronze, neutral of negative. It also provides star ratings, which are based on a quantitative method and is risk-adjusted, cost-adjusted comparison of fund performance within fund categories. These two methods are typical of approaches to rating across the industry, with various elements assigned different weightings.

At the other end of the scale, Rayner Spencer Mills Research (RSMR) does not have ‘levels’ of rating; it either rates a fund or it does not. Geoff Mills, director at the firm, says the firm does not have a rating scale because advisers do not understand the nuances between them and investors do not get it either.

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“Investors want five-star funds in their portfolio but that isn’t necessarily the best way to construct a portfolio,” he says. “Two five-star funds might not work well together, that is not good for portfolio construction.”

For this approach, investors must rely on the fact that if RSMR has rated a fund, it must be worth rating; and conversely that, if it has not, then it has not made it through the firm’s initial screening.

There are strong arguments for both. In either case, advisers should not be selecting a fund on a rating alone. It may contribute to overall choice, but it is unlikely to be the only factor at play.

For analysts that do rate on a scale, there is a risk, as Mr Mills suggests, that investors automatically opt for the ‘best’ rated fund – a fund that may not be suitable for other reasons, or does not fit well with a portfolio. A point of interest, however, is when a rating on a fund changes. From this, advisers can see whether, on a quantitative basis, the underlying fundamentals have improved or, on a qualitative basis, whether conviction is dropping or improving. From this perspective, sliding scales of rating could prove useful.

Ultimately, there is room for both types of fund analysis in the market as long as advisers understand the benefits and limitations of each.