A landmark report has called into question the business models of UK fund ratings agencies amid concerns of inherent conflicts of interest.
The report, compiled by Fundscape and consultancy Gbi2, shows gatekeepers demonstrate a wide disparity in the quality of their research. It says some lack fundamental data, especially around stress testing and details of managers’ strategies.
The report conducted an in-depth analysis of 36 gatekeepers or fund selectors from direct-to-consumer buy lists, adviser buy lists, rating agencies and off-platform lists.
Such lists determine the asset flows into 1,060 funds – roughly 30 per cent of the available fund universe – yet the products account for 96 per cent of industry assets, demonstrating the influence they have on investors.
And worryingly, Gbi2 managing director and report co-author Graham Bentley suggests the market may be skewed by the ability of fund managers to pay for ratings.
He says: “One of the suspicions is if there is a fund manager who is likely to pay you to use the licence to put the rating in marketing material, you may be tempted to rate the fund despite the fact you don’t have all the information you need.
“These people are paying £10,000 to £15,000 per fund to have that rating licence. There is clearly a potential conflict between the commercial interest of the researcher and the pure research.”
Equilibrium Asset Management partner and investment manager Mike Deverell, who carries out analysis in-house, says some agencies only give ratings to funds that pay for them.
He says: “This is both a conflict of interest and also means that small boutique funds tend not to have ratings.”
Bentley cites the Marlborough Special Situations fund, which appears in many D2C lists but “has never had a visit from Morningstar”.
He says: “This is a fund managed by a manager for 16 years beating the All Share index in 61 per cent of the months.”
Morningstar holds data on over 250,000 funds. Approximately 100,000 funds have a Morningstar rating.
A Morningstar spokeswoman says: “Our manager research coverage and ratings is entirely independent of commercial considerations. The research and sales teams are separated internally and it is the manager research team alone who have independent discretion over which funds to select for review and a potential rating.”
Deverell says ratings agencies tend to highlight good or poor performance without explaining the reasons for the disparity.
Bentley adds: “Advisers that outsource funds selection need to understand the process of that selection and what the restrictions are. Most people will not know Morningstar don’t rate the whole market.
“Most advisers naively believe the research companies are constantly going out banging on fund managers doors and demanding to research their funds. In reality they don’t even get round to a lot of funds.”
Are funds rating agencies providing a real service?
Given the fact that fund research isn’t regulated we expressed queries about different business models that these firms have. They’ll do the research but they’ll make their money out selling the licence for the rating, and we looked at whether that had an influence on whether you were rated or not.
If you look at their recommendations instead of looking at the whole universe, is it likely that your resulting portfolio would be any better than choosing funds at random?
One of the key things that came out was it is clear that people using research fund lists are better off than not using them.
However, as we looked at 36 lists, it is also clear that there are some differences between various lists in terms of how heavily accented they are towards past performance rather than subsequent performance.
So for example, if you regress the performance of funds over the three-year period a year ago and then look at the subsequent year, how many of those funds that have high ratings delivered a good result in the subsequent year?
We know from what we’ve been told from fund managers that very few researches actually ask for that data. The one that actually stands out and asks for that is Fundhouse, which currently doesn’t have the profile of the better-known ones.
The idea that research has no commercial pragmatism in it is nonsense. The issue that people really need to understand is what the proposition of Morningstar is, for example, in the UK as it would look at and research 80 per cent of the funds universe. But what happens if you are a very good fund but you are in the 20 per cent?
Graham Bentley is managing director at Gbi2