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Barking mad over wolves in sheep&#39s clothing

When Bates Investment Services questioned the validity of fund risk ratings last week, it had little idea of the difference in opinion it would expose.

Bates&#39s view that risk ratings fail to provide an accurate assessment of likely volatility has been supported by a number of major IFAs but dismissed by others. However, both camps agree that the bear market has been largely responsible for focusing investors&#39 attention on this area.

Hargreaves Lansdown investment manager Ben Yearsley points out that, not so long ago, investors were prepared to accept higher risk as the possibility of losing money seemed a distant prospect. But those days have gone.

“The markets have created worried and angry clients who are now asking their advisers why the fund they thought was low risk has lost them lots of money,” says Yearsley.

The issue has been exacerbated by the crisis in the split-cap sector. One of the FSA&#39s lines of inquiry relates to how splits – and zeros in particular – were marketed as low risk. But whether or not the FSA chooses to make an example of one of the firms in the firing line, it has hardly covered itself in glory in this area, recently admitting that its website also classified splits as lower risk.

All this has resulted in a loss of confidence in the risk ratings attached to funds.

Chartwell director Patrick Connolly says: “We absolutely never pay any attention to fund manager ratings. In deciding the merits of a fund, we would much rather draw our own conclusions than accept the subjective view of a fund manager. Any IFA that pays heed to them should not be advising on investments.”

Connolly&#39s position is well supported. Yet there is a good reason why it is the bigger IFAs who are most vehemently critical of fund risk ratings – they can afford to be. Only the bigger firms have the time and resources to run well-staffed research teams capable of assessing the risk that each fund poses. Many smaller IFAs have to rely, at least in part, on providers&#39 own ratings of their funds.

However, even some of the bigger IFAs believe that risk ratings have their uses. Chase de Vere savings and investments manager Anna Bowes says: “They are a good starting point and should not be dismissed. At the end of the day, it is down to investors and it is their attitude towards risk that has changed, not the risks associated with funds. Investors and IFAs have to work together.”

But Bates head of research James Dalby claims IFAs and investors should disregard fund manager ratings because they give little indication of future volatility. “A fund that is gradually going down is classified as low risk because it isn&#39t volatile. But all clients care about is their fund losing money,” he says.

Dalby supports his criticism with the example of two JP Morgan Fleming funds – the UK dynamic and premier equity growth funds.

Two of the main criteria used to make risk ratings are the number of stocks in a fund and its tracking error against a benchmark. The UK dynamic fund is classified as higher risk because it contains fewer stocks but it has significantly outperformed the premier equity growth fund, which is seen as less volatile because of its greater number of holdings.

Dalby says there are many other examples of funds which have ratings which give a slightly false impression of their likely volatility.

But JP Morgan chief investment officer (Europe) Chris Complin says: “If you are going to redefine risk in that way, then the best-performing assets would be cash. In our case, the higher-risk fund has produced higher returns – it does what it says on the tin – it is just that the general public is interested in absolute returns and the industry is interested in relative returns.”

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