Fund ratings services have come under fire after an FCA review warned that remuneration models pose a challenge to their objectivity. The FCA’s interim report, which forms part of an ongoing review of the asset management sector, also questioned whether ratings services provide enough of a focus on fees relative to performance.
The regulator concluded that lower-cost passive funds, such as exchange-traded funds (ETFs) and index funds, are under-represented in ratings and ‘best buy’ lists offered by platforms (see Table 1).
In what proved to be a damning review of the UK’s asset management industry, published in November, the FCA expressed concerns that advisers may not realise that some ratings agencies are not ‘whole of market’ as a result of their remuneration models.
The review said ratings providers were conflicted because asset managers pay to use the ratings in marketing material, while others pay for their funds to be included in the data sample in order to be liable for a rating.
Although the FCA highlighted some of the shortcomings associated with the services, it acknowledged that they continue to influence allocations. In the watchdog’s analysis, it found that investors reacted to changes in Morningstar ratings. For example, an upgrade to a five-star rating was typically accompanied by a significant increase in the assets invested.
In practice
Given the points raised in the FCA report, are fund ratings fit for purpose?
Abraham Okusanya, a director at investment consultancy FinalytiQ, expects to see the influence of agencies wane as awareness grows about the potential conflicts of interest within their business models.
“It is a conflicted industry, which I hope will diminish progressively. These companies say they will provide ratings regardless of whether a fund house buys the rating, but their revenue and survival is contingent on the fund houses doing that,” Mr Okusanya explains.
In light of their potential biases, he says his firm does not take ratings at face value. The team refers to multiple ratings providers, but only as a point of reference at the end of the due diligence process.
If a fund is not rated, Mr Okusanya says it would not sway the firm’s final decision.
David Thomson, chief investment officer at VWM Wealth, also uses fund ratings at the end of the fund selection process. If his team is interested in a fund that has a low rating, or none at all, this might cause it to go back to the fund management group and ask why, he explains.
In his opinion, it is important to understand the limitations of ratings agencies.
