Is the use of fund rating agencies a risk for your business?

Ben Raven - Head of Business Development

While fund managers and IFAs have certain interests in common (such as positive fund performance) they are by no means fully aligned, and this apparently insignificant misalignment can pose a big risk to an IFA.

A fund manager wants to sell its products into the IFA market. To this end, they will promote everything that IFAs wants to hear; low costs, robust asset allocation, quality underlying research, a specific volatility target and a great track record – all in an effort to persuade IFAs to recommend these funds to their client bank.

An IFA on the other hand is responsible for the ongoing suitability of the fund once recommended to any client. Even before any such recommendation is made the IFA must endeavour to identify, understand and fully explain all types of risk to a client. Cue the fund manager rating agency – a concept which has developed significantly in recent years, and for which there is an enormous reliance within the IFA community.

After all, if an IFA is to verify a fund manager’s sales literature, what better source to rely on than an independent third party whose job is to provide an objective assessment of the fund manager? It sounds like the perfect tool for an IFA – however even the most trusting of IFAs must ask certain obvious questions: a) what are these ratings based on and b) how do they protect me from future complaints? Unfortunately, in many cases the assessments are based on the wrong things and arguably do not provide the IFA with much protection at all!

There is a wide variety of fund rating agencies but there is a considerable degree of overlap on the quantitative criteria set in order to achieve a top rating; minimum length of track record, minimum level of assets under management, minimum number of funds in the range, size of fund management company, research infrastructure and pedigree of the fund manager. Whilst one can argue that these all warrant a place in determining a rating for a specific fund, what protection do these ratings actually afford an IFA?

The ratings, and the criteria upon which they are based, serve the interests of the fund manager (who is also paying for the service in most cases); they focus predominantly on the PAST in an effort to sell into the IFA community in the PRESENT. They do not serve the interests of the IFA who seeks to protect their clients, and indeed their own business, in the FUTURE.

A rating designed to serve the interests of the IFA would have a considerable focus on questions such as;


Is the fund likely to operate at all times within the risk profile stated on the fund factsheet?


What risks, if any, may cause this risk profile to change over time?


If this happens how is my client’s investment likely to be impacted?


What liability would this leave me with as their IFA?

After all, in going to the effort of using a rating agency, an IFA is looking for confirmation that a particular fund is appropriate for a particular client. Given the client’s needs are predominantly based on an ATR profile, what sense would there be in selecting a fund, and using a rating to verify that selection, based on something completely different?

Whilst some rating agencies do base their ratings predominantly on asset allocation and subsequent portfolio volatility, even these methodologies must be fully understood by an IFA prior to placing unequivocal reliance on them. The volatility rating assigned to many such funds uses historical volatility assumptions for the specific asset classes quoted in the portfolio asset allocation; often the usual suspects of equities, bonds, commodities and property. The risk here is that for any globally diversified portfolio, a significant proportion of the underlying holdings are likely to be denominated in a currency other than GBP, subsequently exposing a client to the currency markets. But currency markets are not typically included in the defined portfolio asset allocation. As a result, third party volatility ratings should be taken with a considerable pinch of salt in situations where that overseas exposure is not being hedged back into GBP.

Many IFAs use ratings issued by agencies purely because they are an ‘independent’ third party (despite the financial arrangements they enter into with many fund managers). However, independent or not, their ratings are based on criteria which do not necessarily highlight a number of potential risks to the IFA and their client, such as what percentage of the asset allocation is denominated in overseas, unhedged currency exposure? How could the volatility of the portfolio therefore become misaligned with my client’s ATR profile over time?

To circle back to my opening point – the interests of a rating agency, like those of a fund manager, are not aligned with those of an IFA. Both the rating agency and the fund manager provide the IFA community with limited information, from which the IFA can ultimately make a poor recommendation despite their best endeavours.

Unlike the IFA, both the rating agency and the fund manager are protected in the event of a client complaining about portfolio volatility becoming misaligned with their attitude to risk. The IFA on the other hand, is on the hook for any client who is exposed to a type of risk they were not made aware of at the time the investment recommendation was made. It serves as no defence for the IFA how well that fund may have performed over the previous 5 years, the historical pedigree of the manager, or the size of the research team – the IFA owns the risk for the advice given.

How can an adviser make sure they identify all types of portfolio risk prior to making a recommendation? This aspect of their role has never been more difficult. An IFA has never been presented with a wider range of fund options and third party ratings from which to choose. Unfortunately, however, neither a fund manager’s literature, nor an agency’s fund ratings are produced with the end responsibility of an IFA in mind. Dependence on this information poses a significant risk to many IFA businesses, particularly given market changes over the last decade.

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