InvestmentsApr 27 2015

Benchmarking and ratings

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Benchmarking and ratings

When advising clients, we will often assess their existing portfolio of investments to establish their existing suitability against their attitude to risk as well as taking into account their quantified objectives for the future.

There are many resources available now showing past performance of various investments with lots of commentary about how some view their prospects or review of the investment news. Other providers offer all this in a ‘star’ or ‘shield’ rating giving you a seemingly quick snapshot of if a particular fund might be worthy of further consideration for a client.

But what do these ratings mean? How are they supposed to be used? How do you decide what is right for your particular client? Does it matter if you run model portfolios or select each investment suitable at the time the advice is being given? There is lots to think about so let’s start exploring.

What exactly is it we want to know? For a currently held investment, we might want to know if it has been performing well up until now. Is it suitable for this particular client going forward? If we know their attitude to risk, capacity for risk and how much risk they need to take to meet their objectives, we can start to look further. Many start with past performance – cumulative perhaps.

But this is not the only thing to consider. Has the fund changed management groups, or has there been a replacement fund manager recently? Has the investment objective remained unchanged (if it has changed then past performance may not be relevant)? How are the charges levied (against capital or income)? Are there performance fees and when do they become payable? Has the charging structure altered since the RDR? What are the turnover costs of the transactions in the fund like (is there lots of buying and selling of the fund’s underlying assets)?

“Past performance is no indicator...”

All these factors will affect the past performance as they alter the charges on the underlying fund. For closed-ended funds like investment trusts it is also worth considering the levels of any gearing (both current and historic) and the historic discount – as the past performance data some sources use may rely on share price past performance and not net asset value past performance. Remember that it is net asset value past performance for open-ended funds such as Oeics. Most of this is already reflected in the past performance, but that is the past. What about future potential performance?

We need to re-visit the areas listed above to see if things are changing for a particular fund moving forward. This is where some ratings try to help. Not all ratings look at future prospects. The old star ratings by S&P only looked at past performance and historic standard deviation in order to establish a fund rating, so you need to establish what the ratings actually review.

Inevitably they will review past performance along with other areas such as the fund manager’s performance and credibility, standard deviation/volatility and the fund’s investment style in the current economic environment. From this an assessment will be made of their potential to perform in the future. It is also worth noting that generally the ratings systems are based on three or four different criteria. They also differ slightly between open- and closed-ended funds.

Some providers offer a ‘star’ or ‘shield’ rating giving a quick snapshot of a fund

Benchmarks

Most funds set themselves a benchmark to be assessed against. It is useful for an investment fund’s board to review the overall performance of the fund against an appropriate independent measure. They may additionally measure the fund’s performance against the average of those in their sector to give volatility data.

In the case of closed-ended investment companies such as investment trusts and Venture Capital Trusts (VCTs), look at the Association of Investment Companies (AIC’s) website (www.theaic.co.uk) and review individual fund pages to find their stated benchmark. For open-ended funds you can find a funds risk rating score on the Investment Association (IA) website (www.theinvestmentassociation.org) which is based on European standards. These standards are entirely quantitate; there is no qualitative element.

Let’s look at an example comparing two well-known and popular funds, Invesco Perpetual Income and Growth Trust (closed-ended fund) and Income and Growth (open-ended fund). We will compare them against their benchmark of the FTSE All Share Index. We can see that the falls in the investment trust were slightly larger in July 2013 and October to November 2014 against the index. This may be for a number of reasons: the weighting of the holdings is slightly different than the index, there are other slightly higher risk investments in the fund and the effects of any gearing that may have been in place. Remember that there has also been the departure of one of the most famous fund managers of recent times, Neil Woodford.

We can see in Chart 1 and Chart 2 that comparing the open-ended fund against its own benchmark of the IA UK All Companies sector, it tracks much closer. But this index is an IA index. Not one that can be readily applied to other types of funds.

What to look for

When looking at benchmarks it is important to remember a few things. Firstly, a benchmark that tracks an index such as the FTSE All Share does not include costs. So a fund that tracks an index such as this will commonly underperform that index to the tune of those costs. We call this tracking error.

Second, software companies that offer past performance and ratings may group certain funds together and set their performance against a benchmark defined by them. It is worth noting that in many cases, this is fine as the benchmark correlates to the one used by the fund itself, however, I have found occasions, particularly where small-cap companies or specialist investment areas are being used, where the applied benchmark has been wholly inappropriate.

Third you may agree another benchmark with clients for whom their portfolio is benchmarked on an annual basis. This will be based on your clients’ individual circumstances, the investments they hold as well as the investment time horizon.

So, in conclusion, benchmarks can be very helpful in establishing how well a particular fund has performed in the past against its own set standards and those of their peers. Ratings systems can be a useful starting point when making judgements about the likely future prospects of funds moving forwards, but only if they include some subjective forward-looking analysis.

As always, try to step back from it all and establish a list of questions you want answers to when researching funds, before delving into the world of statistics. But be aware. You might get lots of answers that don’t help you much.