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We have been researching and analysing funds globally for 7 years now and have rated over 150 local and 250 offshore funds.  Advisers ask us many questions around our ratings including how they should be used, and what they actually mean for an adviser selecting funds for clients. This article takes a look at the intention of our ratings.

Our research is qualitative in focus and detailed – we believe that the majority of the evidence and insights do not lie in the quantitative measures of a fund or an investment process. We choose to rather spend a significant amount of time on the qualitative aspects of the business, the team and the investment process, and by doing this the quality of that fund or investment process becomes clearer.  In essence, we try to understand how the team considers the range of investment opportunities, how they make decisions, how the key portfolio manager thinks about investing, and how the business and shareholder will support that manager and his team through an investment cycle – all of these issues are qualitative in nature, not generally measurable by statistics and numbers.

We spend in excess of 50 hours on an initial due diligence of a fund (and materially more time than that for complex funds) – pouring through due diligence questionnaires completed by the managers, assessing each team member and their track record, analysing the fund and how it is managed, reading broadly on views expressed by the portfolio managers, etc.  But at the end of the lengthy process, we distil our view into a rating.  We have chosen to keep the rating categories to a minimum, only having three tiers:

Having only three tiers makes it more difficult for us in some ways as we have to make very definite calls on funds, and there is no place to hide with only three options.  However, we believe that by being forced to express a clear view, the ratings are far more useful to our clients.  Rather than having multiple categories which can create confusion as to whether a fund is actually good or not, our view is that there is less room for uncertainty with the three tiers.  A fund is either a good fund with no material concerns (Tier 1), a good fund with some minor concerns we want to watch over time (Tier 2) or a fund we have given a negative rating (Tier 3).

As a business we do not have a bias towards a particular style of investing – we have active and passive Tier 1 funds, and the active Tier 1 funds have a range of investment styles including deep value, value based, valuation, quality and momentum.  In our model portfolios, we will not include any Tier 3 funds and will only include Tier 1 and Tier 2 funds with a clear preference for Tier 1 funds.

It is very important that advisers understand clearly what each tier means and where the use of the ratings fit into the financial advice process.  Our ratings are not intended as a buy or sell indicator, therefore just because a fund has a Tier 1 rating does not mean that:

a.)    it is suitable for all of the adviser’s clients, nor

b.)    that now is the right time to invest clients in a particular fund.

This is because a big part of a fund’s rating is determining if we believe the fund is likely to achieve what it says it is aiming to achieve – i.e. do we believe that the fund will deliver on its risk and return mandate through an investment cycle.  It is therefore still very important to align the client’s investment needs with the mandate of the fund.  The ratings are aimed at helping advisers by providing comfort that someone with appropriate experience has researched and assessed the fund.  They are designed to help with the portfolio construction and fund selection process, not to replace it.

Another important aspect for advisers to keep in mind is that relying purely on a fund’s tier rating to construct a portfolio might result in a portfolio that blends similar managers.  South Africa is a good example of this, where there are a number of very good fund managers who invest in a very similar way, leading to investment outcomes that are very similar.  They may all be Tier 1 funds, but blindly following the ratings and blending three of these funds to create a portfolio for your clients may not be the best option – the impact of the lack of diversification is likely to be material over time.

It is therefore very important that when you are deciding which funds to invest in and include in a client’s portfolio you do not make those decisions based purely on the tier rating but also read through the fund research report for that fund we publish under the ‘Manager Research’ section of Adviser Online.  The report provides further insight into the style of the manager and how they approach investing.

In summary, the rating is intended as a form of quality assessment of a fund and its investment process and is a contributor to a sound portfolio construction process.  It is not intended as a buy, hold or sell signal on a fund.