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Fund ratings: Time to introduce negative scores?

Fund ratings: Time to introduce negative scores?

Rating agencies have been called upon to increase their use of negative ratings to help investors identify poor funds after the FCA questioned the sector's role in the investment industry.

Interim findings from the FCA’s asset management market study criticised fund raters for not providing enough resources to areas of the market such as passives. The regulator also noted concerns from some industry figures that ratings were only made when financially beneficial to both agency and asset manager, and said it was considering further analysis.

While raters have subsequently defended their business models, some feel they should prove their independence by highlighting poorly managed funds.

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Oren Kaplan, co-founder of ratings firm SharingAlpha, said the number of positive ratings in the industry drastically outnumbered negative ratings due to investor preferences.

“There are more longs than shorts [in terms of positive ratings rather than negative] because that’s the way people look to invest,” Mr Kaplan said.

But he added: “With closet trackers, we could see negative ratings. People won’t back those funds – they will sell them.”

The FCA’s report has renewed concerns about ‘closet tracker’ funds that claim to be fully active but do little more than track a benchmark. The study did not use this term, but did take aim at “partly active” funds – those which seek to stay relatively close to a benchmark but charge active fees for doing so.

Rory Maguire, Fundhouse managing director, said only 3 per cent of mainstream ratings were negative in the UK, despite around 60 per cent of active managers failing to outperform their benchmarks. Fund rating agencies needed to highlight good and poor funds in equal measure to ensure clients were protected, he added.

“Negative ratings should improve many aspects highlighted by the FCA – competition among funds should improve, funds with more value add could charge more and closet trackers would be weeded out.”

However, others were quick to defend existing processes. Jonathan Miller, director of manager research at Morningstar, said ratings should help investors choose the best funds. As a result, the firm spends more time looking for good funds rather than bad.

Morningstar does provide negative ratings, which Mr Miller said were “expressly designed” to call out bad funds. However, these ratings only account for five of the company’s 850 fund ratings (see box).

Mr Miller said: “Our core principle is around helping investors achieve their financial goals. As a result, there is a natural skew towards a greater number of positive analyst-rated funds, given analysts seek out funds they believe have the better opportunity to outperform their peers on a risk-adjusted basis over a market cycle.”

Morningstar analyst ratings conform to a five-tier scale, with gold, silver and bronze ratings indicating a positive rating, and neutral and negative suggesting a poor one.

Richard Romer-Lee, managing director at Square Mile Investment Consulting & Research, said his firm ranked funds based on how closely they meet their stated objectives. He added that Square Mile has issued both good and bad commentary on funds.