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November 29, 2016

Fund Ratings: Separating the Wheat from the Chaff

by Robert Jenkins.

Along the journey to financial independence and security many investors find it necessary to seek out the advice of professionals. Whether those are brokers, financial planners or other industry experts, millions of investors rely on both the quantitative and qualitative knowledge of investing specialists. In fact, Lipper has produced ratings for funds around the globe for decades, all in an effort to ensure investors find funds that are a good fit.

Here are six reasons why investors and experts alike hold Lipper ratings in high regard.

Better peers make better ratings

A hallmark of great data is exceptional organization and no one organizes data better than Lipper. By providing industry-leading fund classification systems around the world, no matter where you’re investing, you can be confident that Lipper has assembled the most appropriate group of similar funds. After all, it doesn’t help to make comparisons between funds that are too dissimilar or by offering more granular classification differences within fund peer groups. For example, an investor may want to research top large-cap value funds which generally invest in very big, mature companies with solid income potential. It would not be fair to compare such funds with those that may only invest a modest portion in large companies or those that buy stock in companies that provide very little income. In the US alone there are 156 distinct fund classifications (the nearest competitor offers just 110). By maintaining high-quality peer groups investors can be more confident about making comparisons and drawing conclusions.

Peer averages are better guages than indexes

Returns generated by fund managers are often compared to a benchmark or index, which is typically a list of securities and their ideal allocation or weight. This is simple: How well did the manager perform next to a portfolio of stocks or bonds that did not have to make daily decisions about news events, interest rates, earnings announcements and so forth? In fact, most investment professionals use this benchmark-relative performance in their own fund evaluation.

But better context is found in peer group averages. Once again, appropriateness is key. An index, after all, isn’t real: It doesn’t contend with investor money going into and out of the fund; it doesn’t have expenses and it doesn’t incur trading costs. By using peer group averages, a better ”real world” comparison is made among managers.

When it comes to expenses, actively managed equity mutual funds in the US cost investors about 0.82% (or $82 for every $10,000 invested) in ongoing fund expenses and even passively managed (or “indexed”) mutual funds and exchange-traded funds cost about 0.18% (or $18 for every $10,000 invested). Not only do expenses pose a drag on fund performance, but maintaining daily liquidity to meet normal redemptions usually means that a mutual fund must maintain some cash in the portfolio, which contributes very little income toward the fund’s returns; as well, many ETFs do not hold the exact proportion or even the precise names as their benchmarks.

Lipper ratings are flexible (but not too much)

First impressions can be important when meeting someone but what if instead of spending a great deal

of time getting to know someone you had a handy synopsis of their successes and failures over the past several years? Fund ratings do just that. By measuring funds over three, five and 10 years, investors develop a sense of the relative consistency (or lack thereof) among their possible fund choices. Wouldn’t it be nice to know that your new acquaintance has a very unpredictable personality at times? Or that some funds’ performance turns especially volatile during market stress, to help you decide whether that much excitement is worth the investment?

Though ratings on any fund are subject to change each month, many funds have very stable ratings. In 2015, among equity mutual funds and ETFs that were rated each month, 75% of them saw their rating change by one place – or not at all – throughout the year. And nearly 20% changed two rating levels (from, say, a 3 to a 4 and then a 5) over the year. Identifying stable ratings may be an important part of an investor’s search.

Certainly, depending on recent performance alone to judge a manager’s skill can be hazardous. In Graph 1, funds from several random categories have their 3-year total return percentile ranks from three years ago plotted across the bottom axis and their next 3-year ranking plotted along the vertical axis. The orange line that runs from corner to corner? That’s where perfectly repeatable rankings would plot. While a bit of variation is to be expected, the seeming randomness of relative success is tough to ignore.

Graph 1. Hard to Know What the Future Holds


Source: Lipper

Quantitative or qualitative

The staggering growth of mutual funds – over 8,000 in the US alone – means personally evaluating each fund’s management team, portfolio and sponsor services would be a daunting undertaking. While there is definitely value to be found acquiring that vast body of knowledge, unfortunately it’s simply too overwhelming for any firm to cover the entire funds industry in a timely, complete fashion. That’s why a quantitative cut of fund choices is necessary.

Toolkit approach

A toolkit to build fund research makes the Lipper ratings stand out from the competition. Funds are rated not only on Total Return (how much money was made or lost?), but also for Consistent Return (is performance relatively bumpy or smooth?), Preservation (how much does the fund’s value swing about?), Tax Efficiency (how well does it protect investors from the Tax Man?), and Expense (is this relatively cheaper to own or not?). Normally, this kind of data is available through professional-level databases, but with the ratings already calculated much of the heavy lifting for retail investors is already done.

This toolkit approach is also a valuable means to help investors avoid the mistake of selecting a fund simply because it has a high rating in one area. Seeing a fund from multiple angles ensures investors are better informed ahead of time.

Ratings are part of the answer, not the only answer

Ratings are very helpful but they certainly can’t resolve every concern from all investors. Some investors prefer funds from large, well-known managers while others seek out the diamonds-in-the-rough. Some investors value a sharp-looking website with frequent fund manager commentaries while others couldn’t care less. Once you’re equipped with the right tools to narrow down your choices, choosing the right fund for its qualitative features is much easier.

The bottom line: do ratings help?

No ratings system is perfect or even complete, but Lipper focuses on results: On average, funds with the highest three-year ratings for Total Return and Consistent Return at the end of 2012 did perform better over the next three years. Funds with high ratings for Preservation – a measure of price volatility and not necessarily performance – weren’t much different than average for total return over the following three years, but Preservation did show that the most volatile funds also underperformed the most three years later.

Table 1. Average Percentile Ranks Three Years After Rating


Source: Lipper 

Where to start?

Fund ratings from Lipper populate many of the world’s leading financial news sources and websites such as, The Wall Street Journal and US News & World Report. In addition to monthly fund ratings, Lipper also honors the very best three-year, Consistent-Return- rated funds with annual Lipper Fund Awards.

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