The good, the bad and the lucky…
Noël Amenc, PhD, Professor of Finance at EDHEC and Director of the EDHEC Risk and Asset Management Research Centre
Noël Amenc
With the development of independent distribution and so-called "open" architecture, the marketing success of mutual funds no longer only depends on the ability of their sales network to sell, but also on their financial performance.
This "financialisation" of commercial competition has resulted in increased attention being given to the performance measurement of investment funds. The French market, for instance, has not escaped the growing influence of ratings and fund classifications by specialist newspapers.
At first glance, this spotlight on performance could be virtuous and allow better informed investors to use the power they have when deciding to subscribe or not to eliminate the worst funds and favour the best. However, mutual fund ratings would in that case have to be rigorous and relevant. Unfortunately, it seems that the scores attributed tend to be arbitrary or lucky rather than the fruit of the manager’s skill.
Compare what is comparable
Very often, the ratings are established relative to a category. The score attributed therefore depends on the choice of category.
However, for want of genuine knowledge about the composition of the rated funds – and therefore an inability to take their style into account – the agency will classify, in a fairly broad category, mutual funds that do not present the same risks and are not comparable, since they do not resemble each other.
The score then rewards the prevailing situation for the style of the fund more than the manager’s capacity to genuinely create outperformance through stock picking or appropriate tactical allocation.
Beware of the reference index
Since they are unable to determine the fund’s true benchmark, most rating methods determine risk-adjusted performance by using an Information Ratio calculated using the reference index of the category to which the fund is supposed to belong. However the Information Ratio is extremely sensitive to the choice of index and when the latter – as is very often the case – does not reflect the allocation of the fund over the calculation period, the excess performance rated is artificial and illusory.
Separating the alpha from the beta
Should this criticism discourage us from attributing any usefulness to the rating of fund performance? Absolutely not, because rating performance is probably the only way to provide information to individual investors and constitutes a factor of efficiency in a market that is much larger in terms of volume than that represented by direct investment on the stock exchange.
They should, on the contrary, be used as a basis for developing methods that are more respectful of the managers’ performance, so that the managers are not the best or worst by accident… This is the direction of the initiative taken by EDHEC and EuroPerformance, who have developed the first fund rating system that distinguishes the manager’s skill (alpha) from the return that is due to the good or bad prevailing situation. The latter corresponds to the premiums for the risk factors (betas) to which the funds are exposed.
