What if we rate investment funds?
“Steve, this supposedly well-managed fund is losing money! My financial planner said it was a good investment, but clearly it isn’t!” a relative of mine remarked to me a few months ago. His adverse reaction towards actively managed funds is not unusual. Although everyone accepts that investment and risk are synonymous, the experience of seeing one’s capital eroding is alarming.
Many investors, who lack investment market knowledge often opt for actively managed retail investment funds, especially if given a little push by their financial planner. The aim of an active fund is to yield, net of fees, a higher level of risk adjusted return than its benchmark, the latter being an index of a weighted average mix of securities. For example, a fund that actively invests in large capitalisation US companies would have the S&P 500 index included in its benchmark and the fund would actively work on earning more than this benchmark.
So what can be done to objectively assess a fund’s value added and its ability to deliver abnormal risk adjusted returns? Is it possible to create a fund rating mechanism which indicates the probability of future outperformance? In other sectors, like corporate credit worthiness, ratings already exist. So why shouldn’t we be able to rate investment funds?
Companies like Citywire have already been issuing, for quite some time, ratings for mutual fund managers. However, the selection process is based on past performance and relative to the pool of fund managers being rated. J.D. Power’s annual US Full Service Investor Satisfaction Study ranks investment companies based on investor satisfaction. Yet this is purely subjective on what investors included in the study feel. Alternatively, Morningstar has developed its Morningstar analyst ratings for funds which is a forward-looking analysis that evaluates funds based on more qualitative measures. This is a good start yet many retail funds are still not rated and a comprehensive fund rating industry, with several rating agencies, is yet to be developed.
A suggested fund-rating mechanism
Although complex, a more holistic approach would be to consider several qualitative and quantitative factors affecting the probability of future returns. Below is a proposed list of variables that can be used in a fund rating mechanism:
Fund manager’s skill
By far the dominant source of investment profit comes from the fund manager’s skill. Managerial skill relates to the asset selection and allocation ability of the fund manager. But how can this be gauged? Although always subjective, proxies could include:
Education. A solid background in finance education should help build superior market knowledge.
Investment experience. The longer a fund manager has been in this business the more likely a winning secutiry will be picked. Avery and Chevalier (1999) find that managers tend to take on bolder and more aggressive strategies as they gain experience due to better confidence and knowledge. At the same time however, more seasoned managers presiding over large funds may become more risk averse and passive over time to protect their income and reputation.
Entrepreneurial experience. Fund managers with a business background are more likely to spot winning companies whose issued securities may be under-priced and have potential for future growth. Entrepreneurial spirit is in fact a very important skill for activist fund managers, i.e. those who, like Bill Ackman, purchase enough equity in companies to affect change in corporate strategy with the aim of maximising the company’s potential.
Past performance persistence. If a fund outperforms its benchmark for a number of consecutive years then this would indicate that returns are more the result of the manager’s skill rather than chance and so it is more likely to further outperform in the future. Historical abnormal returns of a fund should however be linked to the fund manager and if he/she changes, past performance will probably be less relevant.
Size of the fund
Larger funds tend to benefit from economies of scale by spreading costs over a larger pool of capital. However, a larger than ‘optimal size’ fund could be detrimental for other reasons, such as funds which tend to become less actively managed as they grow larger, diluting the potential investment gains derived from active management. What is considered to be the optimal size for a fund would depend on both market and idiosyncratic factors such as fund regulation and the investment company’s infrastructure.
Illiquidity of the fund
The longer the investment lockup period (time for which an investor ties up his savings in a fund), the bigger the potential to invest in less liquid yet potentially very rewarding strategies such as long-term long positions, convertible arbitrage or fixed income arbitrage. Additionally, fire-selling of assets to meet redemptions is less likely.
The higher the expense ratio of a fund, the more difficult it is for it to beat its benchmark. This is one of the reasons why passively managed funds, like Exchange Traded Funds (ETFs), have become so popular. When trying to outperform the market, actively managed funds have the additional hurdle of covering the higher costs associated with active management.
This is not to say, however, that a manager’s incentive fees should be reduced. In fact, some studies, like Edwards and Caglayan (2001), observe that the performance of certain investment funds is positively related to a manager’s incentive fees and Agarwal et al (2009) found that high water mark provisions produce superior performance. Although high water mark provisions may act as an incentive for excessive risk taking, this should be mitigated by the fund’s risk management restrictions.
It is safe to assume that the more invested the fund manager is in the fund, the more driven he or she is to outperform.
Risk management structure
The stronger the risk management structure of the fund, the better protected the investor is. If a fund over performs its benchmark yet it is investing in disallowed high-risk securities, the fund is nonetheless posing a significant threat to investors, since their risk aversion is not in line with these decisions. Since the financial crisis, investment houses have given risk management an increasingly higher profile, significantly strengthening their risk and compliance structures, albeit at higher costs.
For this idea to get off the ground it would need the investment community and the regulator’s support and must not be, nor seen to be, another layer of regulation. It would be targeted towards retail funds, acting as a useful aid to the less educated investor. It would also help boost investor confidence, increase efficiency of capital allocation and enhance profitability for investors. A fund-rating mechanism’s purpose would be to provide an objective indication of a fund’s probability of good future performance rather than a definite answer as to which fund will over perform. If this were the case, it would be very difficult for a fund to beat an efficient market in any case!
The rating system would apply to retail funds for starters. Eventually it could also find an application to institutional or hedge funds even though investors here are usually professionals and consequently very well educated in the investment world.
Perhaps with such a rating system investors, including my concerned relative, would sleep sounder at night since he would know that his money is placed in independently-vetted good quality funds rather than with what his financial planner wants to sell him.
Studies mentioned in this article refer to published academic research papers and have been obtained from online journal databases.