UKDec 7 2016

Risk of relying on fund ratings

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Risk of relying on fund ratings

No, this is not a preamble to another tiresome Brexit scare story. Hiding in the shadows of that rather lurid spotlight there are deeper issues that need to be addressed if UK investors are to achieve the outcomes they seek.  

The savings ratio is the proportion of our disposable income that is saved rather than spent. During the 1980s and 1990s, we parsimonious Brits stoically squirrelled away more than £13 for every £100 we earned.

That figure has steadily declined over the past 25 years. Today, according to the Office for National Statistics, we save less than £4 in every £100. Meanwhile, those savers face the prospect of their savings having to last longer. In 1940, a male retiree expected to live fewer than 11 more years when taking the state pension at 65. Today, that expectation is more than 20 years. A 45-year-old in 2016 might have to fund a retirement of more than 25 years.

People are saving less, to fund a retirement that will last longer.  

Compounding the issue, the returns savers might expect are likely to be substantially lower than those experienced by today’s retirees. Forty years of asset price re-rating were driven by interest rates and inflation falling from 17 per cent and 24 per cent respectively, to virtually zero today.

There is unlikely to be such a driver of asset prices for decades to come. We are absolutely destined to occupy a generally lower return environment. Consequently, today’s investors need to save more and work for longer, while seeking out exceptional returns.

This is where advice comes to the fore.

The suitability imperative requires advisers to have a robust investment process, generally focused on client risk profiling and asset allocation. However, customers’ investments must seek to produce outcomes over time beyond their minimum acceptable return (MAR) – that which is required to achieve their goals – plus associated costs of administration, and any advice. The more mouths there are to feed in the investment value chain, the higher the total cost of ownership (TCO). The higher the TCO, the less likely it is that investors’ objectives will be achieved on schedule.

Increasing returns beyond the beta expected via asset allocation models requires alpha generation via the underlying securities and funds. A robust fund selection programme is no less important than an asset allocation process, and for many advisers this may be their greatest area of business risk.  

Despite the availability of specialist fund research companies, about 70 per cent of advisers continue to claim to select funds and build portfolios themselves. Most of those advisers are unlikely to have full-time, experienced fund analysts, and fund managers are unlikely to give them the same attention they would the commercially significant research companies. 

Consequently, many advisers refer to "free-to-air" ratings awards collated by services such as Morningstar, RSMR, Citywire and Square Mile. Research on ratings services and analysed recommended funds lists from more than 40 ratings agencies, advisers and platforms is clear that the use of researched lists has three key advantages:

•   Virtually all whole-of-market lists identified and avoided serial poor performers.

•    Post-selection, listed funds as a cohort outperformed unlisted funds.

•    It eased the burden of fund selection for advisory businesses.  

However, there is only a small number of funds that appear frequently across lists.  

It was clear researchers could have very different opinions about the same funds; this suggested that some researchers were getting different data from the same managers, or (more likely) their qualitative analysis – for example, interviews with fund managers – was prone to perception biases and/or an overemphasis on forecasting and opinion.  

Some researchers appear to pay more attention to process, or a manager’s demeanour, than the numbers. Most surprisingly, the report found little evidence of a relationship between qualitative research and future alpha, versus pure data driven analysis. 

Assessing suitability requires that the expected behaviour of the funds selected matches the asset allocation box that they are going to occupy in a portfolio. This is the weakness of any adviser process that simply copies and pastes funds from lists.  

Most fund lists do not calibrate to asset classes per se. They are performance and demand led; that is how they get on most researchers’ radars.

Selection is not linked to the weight of assets in the sector, nor is it concerned with the degree to which a fund’s behaviour varies relative to its benchmark. Indeed, many funds choose the sector average as their benchmark rather than the index of the market they represent.  

This can lead to selection error, particularly where the asset allocation model has rigid definitions of the asset classes or, more importantly, where sectors cannot be matched to an asset class; for example, absolute return.

The use of researched lists is growing, but the opportunity to calibrate fund selections to portfolio modelling tools is still largely absent from the market. Perhaps unsurprisingly, Dynamic Planner’s ACE Fund Rating Service (Asset Consistency and Efficiency) – the most recent addition to the pantheon of researched lists – has recognised this mismatching potential.  

Suitability demands advisers take a critical look at their current fund research provider, and align themselves with the research that best reflects their portfolio construction process.

Graham Bentley is managing director of gbi2 Investment Intelligence

Key points

·         The returns savers might expect are likely to be substantially lower than those experienced by today’s retirees.

·         The suitability imperative requires advisers to have a robust investment process.

·         Some researchers appear to pay more attention to process, or a manager’s demeanour, than the numbers.