Analysing the raters

PortfolioConstruction Forum asked the research houses: Of the 15,000 managed funds on offer in the Australian market, how do you determine which ones you will rate, and what the distribution of those ratings is?

Lonsec

Lonsec’s fund research universe is designed to provide subscribers with a well-balanced list of funds from which Approved Product Lists and model portfolios can be prepared.

Therefore factors taken into account when determining what to rate include style and capitalisation biases, uniqueness of investment process, product accessibility, availability across different taxation structures, and Lonsec’s need to offer an adequate diversification of funds within and across sectors.

Lonsec rates 586 ‘underlying’ products (as at 11 February, 2011) which map to 10,500 products across tax and fee structures and platform versions.

This includes structured products, direct property and infrastructure, debt products, alternatives, exchange-traded funds (ETFs) as well as mainstream managed funds.

In addition, Lonsec has research notes on approximately 200 other underlying products where analysts have undertaken quantitative screening and manager meetings, but have subsequently rejected the product on qualitative grounds.

Morningstar

Three broad factors drive Morningstar’s coverage.

The first and most important is client demand. Morningstar offers a user-pays service, so it expect its clients to play a key role in determining its coverage. It is for this reason that Morningstar initiated coverage of ETFs in 2010.

The second factor that drives Morningstar’s research universe is investment merit.

There may be a relatively unknown fund with a minimal track record or small assets base which Morningstar believes has genuine merit.

This gives Morningstar the flexibility to bring undiscovered but worthy funds to the attention of its clients.

Finally, Morningstar also covers the largest funds in Australia, as it’s important for its clients to have an informed view on the biggest funds in each sector.

The purpose of Morningstar’s qualitative research is to determine which fund managers and investment strategies deserve the attention of advisers and investors, and which do not.

The Morningstar Recommendation is based on a five-point scale comprising Highly Recommended, Recommended, Investment Grade, Hold, and Avoid.

Morningstar aims to have fewer funds across sectors in the top two ratings than in the bottom three, on the belief that having a heavy positive bias in no way helps investors and advisers make effective decisions.

Morningstar currently provides recommendations on 44.5 per cent of 9,700 Australian unlisted managed funds, with full research reports on 328 discrete investment strategies, equating to 4,312 individual funds (at 10 February 2011).

Morningstar also publishes research on six listed investment companies and 15 ETFs.

Mercer

Mercer does not conduct research on a rotating sector basis, or have commercial terms for ratings therefore it is able to research any strategy at any time — at its own discretion.

Mercer selects the ratings universe based on four factors: client demand; Mercer’s commitment to fulfilling a role of ‘fund introduction’ to its clients; whether Mercer views the fund’s sector as warranting coverage; and, whether Mercer sees the need for complete sector coverage.

A second stage involves screening for products offering the strongest potential within a sector.

Criteria taken into account in this screening include: how compelling the product appears on paper; feedback from Mercers researchers, consultants and clients; feedback from any research carried out on other product offerings from the manager; the track record of the key investment decision-makers in previous roles; insights from ongoing sector research; and, past performance.

Mercer provides views to advisers on A, B+, C rated funds and Preferred Provider funds, while maintaining internal views on N-rated strategies (provided to dealer group head offices).

Globally, this results in Mercer monitoring 4,330 managers and 22,371 strategies, resulting in 6,215 strategies rated (at 31 December 2010). Locally, this includes 3,850 strategies and 12,294 products.

Standard & Poor’s

S&P Fund Services adopts a broad coverage strategy, choosing to rate as many investment capabilities as possible that meet its ratings criteria.

The coverage strategy is largely driven by the needs of its clients — large wealth management groups who need coverage of correspondingly broad and diverse Approved Product Lists.

S&P rates funds across the ratings scale, including non-investment grade. Its ratings range from five stars (high) to one star (low), and are a measure of its conviction that a manager will consistently generate risk-adjusted fund returns in line with relevant investment objectives and relative to peers.

S&P publishes comprehensive reports for poorly rated products as well as highly rated ones, believing research on lower rated funds provides advisers with the opportunity to understand the rating rationale and identify the risks it perceives to exist with these investments.

S&P rates a total of 1,955 funds (at 11 February, 2011).

Van Eyk

Van Eyk balances the benefits to subscribers of covering a strategy against the suitability of a strategy for an investor’s portfolio.

It rates investment strategies, which are then mapped to funds — that is, a single strategy may be mapped to multiple funds dependent upon the fund’s tax structure or platform it is listed upon.

The initial selection process begins with all comers.

A qualitative process is applied across like fund strategies to determine which are best practice. In most sectors reviewed, it is possible to identify best of breed — however in some cases, it is not and van Eyk does not recommend any strategies.

This approach aims to identify high levels of confidence in the strategies and is supported by quantitative analysis. Van Eyk aims to prove or disprove its qualitative views around true-to-label or the philosophy of the fund manager.

As an externality of this process, van Eyk issues risk ratings at the sector and manager level.

For example, van Eyk is currently reviewing ETFs, not necessarily on the belief that they are the best option for all investors’ portfolios, but because there is a sufficient amount of subscriber interest and demand for independent assessment of ETFs, and further, in some circumstances, ETFs could be suitable for an investor’s portfolio.

Subscriber demand and portfolio suitability together with qualitative views from experienced analysts defines the process van Eyk uses to select what it will rate.

In total, van Eyk rates 3,322 funds (at 11 February 2011), about one fifth of the investable market in Australia.

Zenith Investment Partners

Zenith operates an annual review process of the following asset classes and alternative strategies: Australian Equities — Large; Australian Equities - Small Cap; International equities — Global; International Equities - Emerging Markets & Regional; Australian Fixed Interest; International Fixed Interest; Infrastructure; A-REITs; Global REITs; Market Neutral; CTA/Macro/Commodities; Fixed Interest/Low Vol; Long/Short Domestic; Event Driven; Multi Strategy; Long/Short Global; ETFs; Unlisted Property Funds; and, Agribusiness Products.

At the time of each asset class or alternative strategy, Zenith quantitatively reviews all managers and funds included on the major wrap account and master fund platforms.

For the alternatives strategy review process, this also includes products offered by information memorandum.

This quantitative process and Zenith’s research committee’s subjective views of managers and funds then determines which asset class or alternative strategy it will proceed to complete full due diligence on.

These managers are then invited to participate in the review process.

A fund may not pass the full due diligence research process even though it has passed the initial quantitative screening process, however the majority of funds so as most of those unlikely to pass have already been eliminated in the initial screening.

The number of funds rated per asset class or alternative strategy varies based on the size of the universe, but in general represents the top quartile of funds in each category.

The process considers 1,862 products and 514 strategies (at 11 February 2011).