What's in a fund rating?

PortfolioConstruction Forum asked the research houses: An issue that confuses advisers is widely different ratings for the same fund. The Five Oceans Wholesale World Fund is a case in point, with ratings from investment grade to highly recommended. What rating has your firm assigned it? What does that signify generally? What are the strengths and weaknesses of this fund that result in this rating?

Lonsec

Rating

Highly recommended. This rating indicates Lonsec’s high conviction that the fund can achieve its objectives and, if applicable, outperform peers over an appropriate investment timeframe.

The manager or product has strong competitive advantages in people, process and product design and has no areas of material weakness. The investment is a preferred entry point to access this asset class or strategy.

Rationale

The fund is a benchmark unaware, concentrated, long-biased long/short global equity product.

The investment team is centrally located in Sydney and Lonsec considers it to be high quality and suitably resourced to implement this investment strategy.

Key strengths include the considerable investment knowledge and experience of the portfolio managers Chris Selth, Kim Tracey and Piers Watson, who each average 16 years of portfolio management experience.

The investment process is logical, thorough and well implemented. The research and portfolio construction process is based on leveraging off the knowledge, intuition and skills of the lead portfolio manager and supporting key portfolio managers.

The investment process focuses on bottom-up fundamental research with a strong emphasis on valuation.

Research is a rigorous process focusing on a business’s position within its market, market pricing, and the broader economic and social environment in which it operates.

An important component of Five Oceans’ research process is the focus on the identification of catalysts to release value.

Lonsec believes this provides a strength, not only in terms of a robust sell discipline, but also with the timing of stock purchases (ie, avoid buying too early).

Given the absolute nature of the strategy, the fund is suitable for investors who are seeking some downside protection and capital preservation via the manager’s ability to reduce the fund’s net equity market exposure (beta) and its ability to exploit shorting opportunities.

Shorting can be implemented within the portfolio by way of standalone shorts, stock hedges or pair positions, as well as futures and options hedging.

Another strategy that the manager brings to the fund is the ability to actively manage currency as a way to reduce risk and protect capital.

Five Oceans can hedge the full gross exposure of the fund back into Australian dollars, or currencies that it believes offer better value.

In addition, Lonsec believes the firm’s culture, boutique nature and high alignment of interests via co-investment in funds and equity participation bodes well for investors.

Standard & Poor’s

Rating

Four stars. This rating reflects S&P’s high conviction that the manager will consistently generate risk-adjusted returns in excess of relevant investment objectives and relative to peers.

Rationale

This global equities fund employs a high-conviction fundamental stock-picking approach qualified by macro views. It aims to add value by exploiting structural shifts and changing market dynamics.

The investment process is clear and rigorous, and supported by industry-standard systems. The portfolio manager and risk manager have a good grasp of global macro themes and efficient hedging mechanisms.

The fund has been in operation since July 2006, allowing S&P a high-conviction view on risk-adjusted performance.

The fund’s absolute return focus and high-conviction style allows it to make bold allocation choices, which produced mixed results for investors in the early months of its life.

However, results have improved in the period since the last review.

Recent overall portfolio positioning and hedging decisions have revealed the manager’s considerable skill from the top-down as well as from the bottom-up. This is emerging as a significant point of difference among peers.

Five Oceans is staffed by a mid-sized, high quality, and seasoned team of analyst/portfolio managers, in whose abilities S&P has confidence.

The team is impressive relative to peers in terms of the experience and calibre of its members, although it is relatively small compared with peer funds. It exhibits a strong and independent boutique culture, and is majority owned by the six senior executives.

Team members are provided incentives and fund performance fees are calculated with reference to an absolute return benchmark. This aligns the interests of investors with those of the investment team.

The fund does display some weaknesses and risks.

The main weakness is its use of a traditional prime broker model, which introduces asset custody risk due to securities being commingled with other clients’ assets.

S&P views this as less than best practice, which provides for asset segregation and identification held separately from the prime broker so client assets are not commingled.

There are also certain risks associated with the fund that investors should understand. It can take short positions which have unlimited loss potential and introduce credit risk; it may make long/short pairs trades where money can be lost in both positions; it uses derivatives; and, there is foreign exchange risk.

Van Eyk

Rating

BB. This rating indicates that van Eyk has identified strengths with regard to people, process and business management, but has less confidence in the manager outperforming its benchmark in comparison to A-rated managers, on an after-fees basis. Only 29 per cent of strategies were awarded a higher rating in the relevant review.

Rationale

The portfolio manager, Christopher Selth, is experienced and able to effectively combine detailed stock knowledge with a strong awareness of global trends.

Selth is supported by competent senior investment team members, although the team is slightly small when compared to some other, more highly rated managers.

The team travels less extensively than some of its higher rated peers and may lag in identifying insights into local consumer trends and market dynamics.

The team of supporting analysts has expanded in recent years, which is a positive development.

A competitive strength in the investment process is the integration of top down insights and collaboration with industry experts to identify themes.

A key drawback is the base fee of 1.25 per cent, which is high relative to peers. In addition, a performance fee of 20 per cent of returns over 5 per cent is charged.

Zenith Investment Partners

Rating

Recommended. This rating indicates Zenith’s view that a fund is a strong investment within its respective asset class, typically rating first quartile on most criteria.

Rationale

The ownership structure of the business (75 per cent ownership by staff, 25 per cent by Challenger) provides a greater incentive structure for the investment team while also having the backing of a larger, stable financial house.

The investment team is of high quality with a good depth and blend of experience (five seniors and four more junior members), led by an experienced and highly regarded lead portfolio manager, Chris Selth.

Zenith also regards the BT pedigree of four of the five senior members as a positive, recognising that the training provided by the organisation appears to have instilled a solid base for investing globally.

The research produced by the team is among the highest quality Zenith has seen in terms of clarity, depth and breadth.

Another key positive is the manager’s approach of investing from the standpoint of an Australian investor, recognising that movements in the Australian dollar can materially affect returns to Australian investors (a point ignored by many overseas-based managers).

A weakness is a comparatively small team for a global equities manager.

Also, the business has broadened its mandate offerings in recent years (to include 130/30, China Fund, Asia Fund), which may leave the investment team stretched in coverage and focus.

Finally, the relative level of funds under management (approximately $250 million at the time of Zenith’s review in June 2010, although this has increased since) results in the staff equity having low current value, possibly not acting as a strong retention mechanism.

Morningstar

Rating

Investment grade. This rating indicates Morningstar’s view that it is a competent strategy that either fails to stand out, or has offsetting positive and negative factors. While not a strategy Morningstar would recommend, it should get the job done.

Rationale

The strengths of this strategy are the experienced and insightful investment team, the flexible mandate both in terms of risk constraints and derivative and shorting ability, and strong performance since inception.

However, weaknesses are the poorly structured performance fee, the flexible mandate can be a double-edged sword, and variable market and currency exposure can make it hard to deploy in a portfolio context.

Morningstar

Rating

Investment grade. This rating indicates Morningstar’s view that it is a competent strategy that either fails to stand out, or has offsetting positive and negative factors. While not a strategy Morningstar would recommend, it should get the job done.

Rationale

The strengths of this strategy are the experienced and insightful investment team, the flexible mandate both in terms of risk constraints and derivative and shorting ability, and strong performance since inception.

However, weaknesses are the poorly structured performance fee, the flexible mandate can be a double-edged sword, and variable market and currency exposure can make it hard to deploy in a portfolio context.