With the proliferation of advertising and promotion, and the internet, separating the wheat from the chaff when selecting funds and products is paramount.
We are all now pretty familiar with the media reporting downgrading of global economies or, more refreshingly, highlighting a positive trend with an upgrade, but what function do these “ratings” agencies fulfil? The key players on the macro level are Standard & Poor’s, Moody’s and Fitch, and what they do is, in simple terms, apply a marking or grading system to the financial health and creditworthiness of a government or corporation. On the basis of this, interested parties can make an assessment of the potential “risk” of lending to the organisation being rated, including the thorny question about the potential for default.
“The reasons for ratings adjustments vary and may be broadly related to overall shifts in the economy or business environment. Or they may be narrowly focused on circumstances affecting a specific industry, entity or individual debt issue”.
As a broad yardstick, the output from global ratings agencies does have considerable influence on day-to-day economics and markets, notwithstanding the sudden impact politicians and policy-makers can have on this.
Scaling things down to the world of investment funds and the many fund houses and providers, the complex issue of “ratings” is a minefield for advisers and clients to make any sense of. It is essential to bear in mind that credit risk rating agency output is not the same thing as the risk rating that agencies apply to investment funds.
When considering funds to include in a portfolio, the adviser needs to be very clear on the value the leading ratings providers can add to the decision-making process when selecting funds for a portfolio. Examples of the leading players are Morningstar OBSR, Citywire, FE Crown and Trustnet Alpha managers.
Ratings agencies function within the financial services business by delivering “independent” ratings on investment funds and fund management teams. This information is intended to provide potential investors with guidance and data on exactly which funds and managers are performing well.
The most important issue is that advisers follow a robust and demonstrable and comprehensible investment process. This may or may not rely upon input from ratings organisations to provide third-party objectivity and quality measure to overlay on the quantitative data.
Good research and fund selection should only use ratings to provide a measure of quality of funds being considered, not the other way round; just because a fund or fund provider has “ratings” or stars does not mean the fund is a “shoe-in” for any portfolio. All ratings do is steer the IFA’s thought process and help him to reach a well-researched fund selection outcome.
The key areas of risk that advisers and their clients must take on board during the decision-making process on fund selection and asset class are:
- Credit risk.
- Currency risk.
- Inflation risk.
- Taxation risk.
- Market risk.
While ratings agencies can provide some input on this, they do not cover all the bases.
In the new post-RDR world, do they make the fund selection process more transparent?
A major driver of the retail distribution review was to make things clearer and more transparent for potential clients to understand what was being proposed, and the costs and implications. As part of this change, fund costs and charges have undergone a root and branch change, and it should be beneficial for clients and their advisers.
For example, consider the current way ratings agencies assign a score or measure to bonds. Many people will or should be familiar with the terminology AAA, BBB, BB and C when attached to the marketing material promoting a particular investment proposition. The letters indicate a rating measure of “quality” as follows:
- AAA — Top for safety and risk.
- BBB — Relatively safe.
- BB down to C — Speculative or junk and risk of default.
So, as a crude rule of thumb, the adviser and/or their client can make judgements on the funds bearing the different gradings and the risk inherent in making an investment.
Where investments are not bonds in nature, different ratings agencies will attach a variety of rankings and labels, and it is down to the adviser to evaluate what they mean and their use in the fund selection process.
One well-known ratings provider regularly reviews, comments on and ranks individual fund managers in terms of their risk-adjusted performance over different time frames, awarding AAA or AA or A ratings to those individuals and investment teams who meet or exceed pretty demanding performance criteria. Advisers can use this information as part of their due diligence on risk, but it is only one piece of the jigsaw.
Another mainstream provider of ratings publishes its analysts’ views on individual funds and how well it believes they will perform in relation to their benchmark. It will also consider the risk inherent in their investment strategy over five- and seven-year economic cycles. There will be an emphasis on:
- The fund manager or team.
- Delivery and consistency of investment process.
- Adherence to the stated investment strategy and how it translates into returns for investors.
- Charging structure and the offer of fair value.
- Financial strength of the investment house.
- Outcome of the careful analysis of these criteria results in a fund being given a Gold, Silver or Bronze rating.
This does create problems for advisers when it comes to differentiating between these ratings, deciding which ones to rely on and how to communicate this to investment clients.
In 2010, the Committee for European Securities Regulators produced some important consultation documents around the proposed introduction of Key Information Documents (KIIDS) to provide clear concise information on Ucits funds.
- The proposed methodology should produce a rating that is reliable and easily understood by non-financial experts.
- It should be simple to calculate and to replicate (to avoid inconsistencies between providers).
- It should have the potential to be applied to a wide range of investment funds and products.
In 2014, the requirement of KIIDs for investment clients is part and parcel of day-to-day business, and has gone some way to provide clarity on the risk factors inherent in individual funds.
Whether or not this supports the position of risk ratings is a matter for debate, but it does not take away the requirement for adult discussion between adviser and client, and detailed risk-profiling prior to making any investment decisions.
Nick McBreen is an IFA of Worldwide Financial Planning
