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Weaknesses of fund rating services
Fund ratings ignore critical qualitative details

The Canadian mutual fund industry now boasts four major fund ratings services: Gordon Pape's dollar signs, Fundata's FundGrade letter grades, and Globefund and Morningstar's star ratings. There are others, but these are the ones available to the public. In January 2000, only Pape's rating was available to web surfers free of charge - the others either didn't exist or hadn't yet arrived in Canada. Chicago-based research firm Morningstar Inc. is considered the king of fund ratings in the US and internationally. Should investors rely on these ratings for their investment decisions? I say use them cautiously as a first step, not the only step, in the investment decision process.

Benefits, or lack thereof, of automation

All major fund-rating services have one thing in common - they brag about the "automated" nature of their ratings. That is, whether you're looking at ratings from Globefund, Morningstar, or Fundata, all are run by a computer model and are based strictly on past fund performance. The problem: The rating systems doesn't care, for example, that Dynamic Fund of Canada used to be a resource-heavy mid cap fund or that Spectrum Canadian Growth fund has had three very different management teams during its long history. The notable exception here is Gordon Pape's dollar signs (ranging from $ to $$$$). Though he uses some quantitative measures, the rating often isn't finalized until some of Pape's subjectivity is mixed in. As we saw in last week's article, qualitative information is a critical factor when choosing an investment fund.

Peer group vs. benchmark comparisons

All fund-rating services, with one exception, compare funds only against other funds in the same category. For instance, Mackenzie's Ivy Canadian fund will be compared against other diversified Canadian equity funds, but not against the S&P/TSE 60 or TSE 300 stock indexes - the nation's barometers for Canadian stocks. So, if a fund happens to be the best of a terrible group, it will get a good rating by Globefund and Morningstar. Only Fundata's FundGrade, which rates funds relative to a benchmark index using letter grades from A to E. A fund investing in Canadian stocks must outpace the TSE 300 Total Return Index in order to earn a grade above C. If it doesn't beat the index, it can never get beyond a mediocre rating.

The influence of recent performance

Some rating methods give last year's performance a weighting that is equal to performance from ten years ago. Others actually place a higher weighting on the most recent year's performance figures. The problem with this is that a fund having an exceptionally good year will see its rating boosted. The problem with this is that we know that funds that post extraordinarily good returns in one year are very likely to falter the next. While some may disagree, I'd prefer to see some tinkering with this whereby exceptionally good performance in the most recent year is actually given a lower weighting. For instance, when AGF Aggressive Growth turned in an eye-popping 195 per cent return in 1999, its rating should have been adjusted downward. Remember, if you didn't make it in time for the party, you'll be more concerned with what might happen after you arrive. The past is important, but ratings should be forward looking.

Equal treatment is less than ideal

Finally, all automated ratings treat all funds equally. For instance, fees are much more important on bond and income funds as compared to science and technology funds. In fact, none of these automated ratings accounts for costs explicitly. Only Pape's methodology, which has some subjectivity, makes these judgement calls. The fact is that rating all funds in all categories according to the identical methodology fails to capture the elements that influence future performance.

Predictive ability

All of these rating systems have been careful to note that they haven't proven to have any predictive ability. However, Morningstar stands out as a company that implies its rating system influences the amount of cash flowing into various funds. In a recent press release, Morningstar claims that investors favour funds that are graced with the firm's five-star rating. However, what the release fails to mention is that both investors and the star rating system are influenced by more recent performance. So, are investors influenced by Morningstar's ratings? I doubt it. They're simply both drawn by the same main characteristic - great performance over the past year or two.

One final note on predictive ability, there is one firm which boasts its own rating system of diamonds. It claims that it has proven its predictive power - measuring performance of its highly rated funds during the system's first four and a half years. The problem: statistical proof is unlikely to be possible in such a short period of time unless both the frequency and amount of outperformance are substantial. The ironic part about this particular claim is that this firm's president is associated with a magazine that trashed fund rating books a couple of years ago, but the magazine hasn't put this firm's ratings to the same tests it used to trash others. So what's the firm's name? I prefer not to mention it because they release only very limited information about their methodology.

Conclusion

Having studied many fund-rating methods, it is my opinion that these computer-generated ratings have severe limitations. They'll rate a fund's past performance but will give you no indication of how it will perform in the future. In fact, none of the popular rating services have proven, statistically, that they can predict future winners. There is little to nothing in these ratings that emphasize factors that we know have some impact on future performance - costs and stock price valuation - or on important qualitative factors that provide greater insight into a fund's history and future.

Given these facts, go ahead and use these fund ratings. There is an enormous and ever-growing universe of investment funds and you need something to filter through all of the garbage. But bear in mind that these ratings should be just one step in choosing quality investments.

Dan Hallett, CFA, CFP is the President of Dan Hallett & Associates Inc. in Windsor Ontario. DH&A is registered as Investment Counsel in Ontario and provides independent investment research to financial advisors. He can be reached at dha@danhallett.com
 
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Disclaimers: Consult with a qualified investment adviser before trading. Past performance is a poor indicator of future performance. The information on this site, and in its related newsletters, is not intended to be, nor does it constitute, financial advice or recommendations. The information on this site is in no way guaranteed for completeness, accuracy or in any other way. More...