EDHEC-Risk - EuroPerformance/EDHEC-Risk Institute Style Rating

EuroPerformance/EDHEC-Risk Institute Style Rating

Increasingly demanding standards in terms of relevance and scientific rigor

The rating of mutual funds has been growing considerably not only in the United States but also in Europe. It provides an answer to a legitimate expectation on the part of investors and their consultants, who are concerned about comparing the performances and value-added of management offerings that are both increasing in number and becoming increasingly easy to switch in and out of, as a result of the arrival of “open” distribution architecture. A corollary of the success of ratings and their growing influence on the collection of capital is that users are increasingly demanding with regard to the relevance and methodological rigor of the performance evaluation system implemented. In point of fact, the classifications of the main rating services on the market no longer meet the principles of reliability demanded by both investors and management companies.

These demands are the following:

Genuine integration of risk in performance measurement
Measuring performance persistence
Robustness and reliability of the results obtained
Transparency and legibility of the ratings

In favour of genuine integration of risk in performance measurement

We have taken stock of two major difficulties in the area of integrating risk with the rating methodologies that are currently available:

Measuring the risks that were really taken by the manager

The risk-adjusted measure, which is a core element for rating mutual funds, often refers to the average performance of a category or to an index, without the agency really being certain that the category or the index truly represents the strategic allocation and, by extension, the risks to which the fund was exposed.

A fund which claims to be large-cap and which, in fact, presents non-negligible exposure to the small-cap style, could, in certain periods, outperform the large-cap category, even though this outperformance would not really reflect the manager’s value-added in terms of stock picking or market timing.

Empirical studies have shown that the measurement methods for the risk-adjusted performance relative to a predefined index or category generally lead to “atypical” managers, whose allocation does not correspond to that of their category, being rewarded.

When the index determines the winner:
Influence of the choice of index on the information ratio and the fund rankings.
Ranking of Italian equity funds by their Information Ratio compared to the EUROSTOXX 50 and the MIB 30

In order to cope with this difficulty, the EuroPerformance/EDHEC-Risk Institute Style Rating relies on a two-stage risk-adjusted performance measurement “process”:

Determining each fund’s own benchmark, using the style analysis developed by Nobel Prize winner William Sharpe in 1992. This style analysis allows the indices that are truly representative of the fund’s allocation to be selected.
Calculating the fund’s alpha, by employing a multifactor model that uses the indices selected during the first phase as risk factors. This fund-specific calculation is independent from any classification category.

The integration of extreme risks

Most rating methods do not explicitly integrate or do not attempt to measure the funds’ potential for extreme loss.

Whether it involves the indicator chosen (information ratio, volatility) or modelling the aversion to risk, the risk-adjusted measures consider that the investor is averse to the average risk of the investment, but has no particular opinion in relation to extreme losses.

In order to cope with this deficiency, the EuroPerformance/EDHEC-Risk Institute Style Rating implements a realistic Value at Risk calculation based on a Cornish Fisher-type semi-parametric approach which allows the extreme risks associated with non-normal return distributions to be taken into account.

Integrating third and fourth order moments into the measurement of extreme risks enables a good estimation of the fund’s maximal loss to be obtained, for each VaR, with a confidence threshold of 99%.

A good Sharpe ratio is not always exempt from extreme risks
The Values at Risk of the 15 best funds ranked according to their Sharpe ratio
3,265 equity funds have been ranked according to their Sharpe Ration and VaR. The top 50 Sharpe ratios are listed with their VaR.

Measuring performance persistence

The rating is used by investors not only to reward past performance, but also to make investment decisions. From this point of view, a fund’s capacity to reproduce its performance is a key question for the users of the ratings.
Unfortunately, in spite of its usefulness, persistence measurement is not of major concern to rating agencies.

The EuroPerformance/EDHEC-Risk Institute Style Rating has fine-tuned persistence measurement by distinguishing between the capacity to deliver alphas frequently over the analysis period (gain frequency), on the one hand, and, on the other, the capacity to produce this outperformance regularly without too high a degree of volatility (Hurst exponent).

The first dimension of persistence measurement aims to identify the managers who “repeat” their performance, the second to evaluate the likelihood that when the investor subscribes to the fund, the outperformance will not be too different from that observed at the time when the decision was taken.

The robustness and reliability of the results obtained

All the rating methods favour rankings that relate to the funds’ performance.

This approach makes the ratings attributed depend totally on the definition of the categories. However, as we have stressed, the increasing numbers of products and managers prevent the rating agency from being sure that the funds in the same category resemble each other.

The ratings proposed therefore include funds that do not present the same level of risk.

In order to respond to this difficulty, the EuroPerformance/EDHEC-Risk Institute Style Rating was designed as an absolute rating that relies on comparable arithmetic magnitudes (alphas, Value at Risk, gain frequency, Hurst exponent), calculated specifically for each fund and therefore totally independent from any categorisation.

The transparency and legibility of the ratings

As a major element of information for both investors and management companies, the fund ratings should be transparent and easily understood.

Transparency does not just involve describing the calculations and the rating criteria chosen, it also means allowing the users to recalculate and check the rating. This transparency requirement is essential because it guarantees the reliability of the information disseminated.

Moreover, as a communication tool, the rating must be easily understood and rely on calculations that are meaningful for both professionals and private investors.

The EuroPerformance/EDHEC-Risk Institute Style Rating aims to provide the greatest degree of transparency and the best possible level of legibility.

In terms of transparency, the EuroPerformance/EDHEC-Risk Institute Style Rating uses published data (fund and index returns) that are easy to verify. In addition, the rating criteria rely on calculations and methods that have been the subject of numerous academic and professional publications and that are in the public domain today (style analysis, multifactor model, Cornish Fisher VaR, Hurst exponent).

The EuroPerformance/EDHEC-Risk Institute Style Rating uses no proprietary techniques but, on the contrary, uses concepts that are subject to broad consensus in the financial community.

In order to facilitate comprehension, the EuroPerformance/EDHEC-Risk Institute Style Rating relies on simple but key concepts for portfolio management:

the measurement of excess performance (alpha) compared to the fund’s benchmark
the measurement of potential extreme loss (VaR)
the measurement of the frequency with which the outperformance is repeated

It should be noted that the Hurst exponent, which remains a sophisticated technique, has, as a result, been considered as a complement to the rating, so that the rating can keep its simple and easy-to-understand nature.

Rating the ratings

	Aptimum	Lipper	Morningstar	S&P	EuroPerformance-EDHEC-Risk Institute
Integration of the real risk of the fund	Yes	No	Yes	No	Yes
Integration of the extreme risks	No	Yes	No	No	Yes
Integration of the persistence	Yes	Yes	No	No	Yes
Robustness and reliability of the ratings	Yes	No	No	No	Yes
Transparency and legibility of the ratings	No	Yes	Yes	Yes	Yes

The EuroPerformance/EDHEC-Risk Institute Style Rating

The EuroPerformance/EDHEC-Risk Institute Style Rating is put together from three criteria:

Risk-adjusted performance (or alpha)
Potential extreme loss (or VAR)
Performance persistence

For each of these dimensions of the rating, the EuroPerformance/EDHEC-Risk Institute Style Rating relies on the most advanced conceptual and technical research.

Measuring alphas

The risk-adjusted performance is measured in a two-step process.

The first step aims to select the style indices that represent the strategic allocation and therefore the risks taken over the rating period. This analysis is carried out in the form of a constrained multi-linear regression such as developed by William Sharpe.

Using this fund-specific style index selection and the related weights (customised benchmark), the second step involves calculating the fund’s excess performance while taking the risks to which it was really exposed into account. In order to do this, we use a multifactor index model which constitutes a robust and practical application of modern portfolio theory (Arbitrage Pricing Theory).

In order to limit the risks of collinearity between the indices, the fund universe was divided into 17 distinct categories using the EuroPerformance classification groupings.

Style Analysis Category

French Equities
Euro Zone Equities
European Equities
Germany Category
Italy Category
North American Equities
Japanese Equities
Asian Equities
International Equities
Emerging Countries Equities

Euro Zone Bonds
High Yield Bonds
European Bonds
International Bonds
Hedged International Bonds

Euro Balanced
International Balanced

Determining the potential extreme loss (VAR)

The concept of Value-at-Risk (VaR) allows all the portfolio risks, which are spread between several asset classes, to be summed up in a single value. While a measure such as the variance characterises the average risk of the portfolio (mean dispersion in the return distribution), the Value-at-Risk refers to a value for the possible loss; in this sense, it is a measure of extreme risk. The principle behind the VaR concept is therefore simple, but its practical implementation is more complex.

By estimating a Cornish Fisher-type semi-parametric VAR, the EuroPerformance/EDHEC-Risk Institute Style Rating allows for the integration of the potential (to a 99% threshold) extreme loss for funds that present non-Gaussian return profiles, i.e. funds that do not respect a “normal distribution”, either because they invest in markets where the extreme losses are considerable, or because they use derivative instruments.

Performance persistence analysis

The performance persistence measure implemented by the EuroPerformance/EDHEC-Risk Institute Style Rating relies on two indicators:

The calculation of the gain frequency, which measures the frequency of positive alpha over the whole period on a weekly basis, and which aims to identify the managers who “repeat” their performance
The Hurst exponent, which is a measure of the regularity of the outperformance, and which aims to evaluate the probability that, at the subscription stage, the outperformance will not be too different from that observed at the decision-making stage

Rating eligibility rules

The funds that are eligible for the Style Rating have the following elements:

at least 3 years of historical weekly return data
not more than 2 returns missing for the previous 156 weeks
an adjusted determination coefficient (R²) greater than 70% for the alpha calculation model
a Value-At-Risk at the time the rating is calculated that is lower than the average VaR of its analysis category increased by 2 standard deviations (σ).

The funds belonging to the following categories are excluded:

Treasury Funds
Guaranteed Funds
Gold and Raw Material Sector Funds
ETFs and all funds practicing index management

Finally, the Convertible Bonds category is not analysed because there is no style index for this category.

The rating presentation categories

The scores attributed by the EuroPerformance/EDHEC-Risk Institute Style Rating are independent from any category and, as such, are perfectly comparable, whatever the type of fund rated.

Nonetheless, in order to simplify the presentation of the ratings, seven categories have been defined so as to make the ratings easier to read and to understand.

Presentation Category

European Equities
American Equities
International Equities
Emerging Countries Equities

Euro Bonds
International Bonds

Euro Balanced
International Balanced

Rules for attributing stars

The EuroPerformance/EDHEC-Risk Institute Style Rating is updated every month. The behaviours identified by the EuroPerformance/EDHEC-Risk Institute Style Rating are stable and do not require the implementation of rating management rules that limit its variability.

Rating Attribution Table

Communication

The Style Rating is a measure of the quality of active management. The Style Rating criteria are demanding and fewer than 10% of the funds rated obtain the maximal rating of *****.

The 1 and 2 star categories contain funds that do not outperform their objective on average. These funds were able to deliver positive performances over the period analysed while not exceeding the average performance produced by the indices that are representative of their strategy.

The 3 star category contains funds whose performance is very similar to that of the markets in which they are invested. Their outperformance nonetheless allows them to cover the average management fees in their category.

The 4 and 5 star categories contain funds that outperform over the analysis period. This excess performance is the fruit of the manager’s decisions: active stock picking and/or market or style timing.

Among these funds that excel, some provide a significant gain frequency that characterises persistence of outperformance. These funds are distinguished by the maximal rating of 5 stars.

Finally, the 5 star H (Hurst exponent) category distinguishes funds that regularly outperform their benchmark. The ‘H’ is a decision support tool because it indicates that the investor has a better than average chance, at the subscription stage, of benefiting from good performance of the fund chosen.

The right to use the EuroPerformance/EDHEC-Risk Institute Style Rating is provided free of charge on condition that the source of the rating reproduced is cited. Details on the conditions and limitations of the use of the Style Rating are given on our website.

The Style Rating results are published on the 4th Friday of the month on the following website: http://www.stylerating.com. The site provides details on the evolution of the rated funds and lists the funds excluded from the style rating. The technical documentation is also available on the website.

The cooperation between EuroPerformance and EDHEC-Risk Institute

The EuroPerformance/EDHEC-Risk Institute Style Rating associates EuroPerformance and EDHEC-Risk Institute. EDHEC-Risk Institute is the scientific adviser to the EuroPerformance/EDHEC-Risk Institute Style Rating.

EDHEC-Risk Institute was set up in 2001. Its team of 46 research engineers, specialised associate researchers and professors work together on applied research programmes in the areas of asset allocation and performance measurement in the traditional and alternative universes.

EuroPerformance is a performance analysis and measurement agency for European investment funds. Its business is structured around three activities:

Daily dissemination of fund data
Studies on asset amounts, subscriptions and style analysis
Solution provider for fund selection and performance reporting

EuroPerformance is a subsidiary of the Fininfo group.

Scope of the ratings

The EuroPerformance/EDHEC-Risk Institute Style Rating is currently applied to funds in France, Switzerland, Spain, Italy and the UK. With its demanding selection criteria, 2,900 funds have qualified to receive the rating following the screening process. It is worth noting that fewer than 10 percent of funds receive five stars.

From 2005, the EuroPerformance/EDHEC-Risk Institute Style Rating has been extended progressively to cover all of the funds marketed in Europe.

Related research

"Rating the Ratings: A Critical Analysis of Fund Rating Systems"