Fund Library offers new ratings system

(August 23, 2004) For many novice investors, mutual funds are a good place to start, offering instant diversification and an occasionally clear statement of how the manager invests. They are relatively simple for an advisor to explain, but most clients still like to see some kind of independent research, telling them what they can expect from a given fund.

The problem is, the easy-to-understand ratings systems available to the public primarily indicate past performance — not exactly useful in an industry where the standard disclaimer warns “past performance does not guarantee future results.”

To address this, The Fund Library, a fund investing Web site (fundlibrary.com), has launched a new ratings system, in a market where Morningstar Canada and GlobeFund already assign ratings to virtually every Canadian mutual fund.

“Having looked at the ‘current fad’ ratings systems that are out there, I was unhappy with not necessarily how they were marketed, but the way they have been received by investors,” says Levi Folk, president and managing editor of The Fund Library. “Basically they are a form of performance measure and in that sense they are backward looking. If you have a five-star fund, these are really funds that have done well in the past, either based on risk and or return. If you have strong returns, you tend to have a high rating.”

By “current fad” Folk is referring to the transitory nature of ratings that focus on past performance, which favour funds that are in the latest “hot sector.” For example, a five-star technology fund in December, 1999, might not have looked so attractive six months later.

“The problem is that investors are often buying funds that are historically good performers but not necessarily future good performers,” says Folk. “They’re buying at the top of the market many times.”

But Folk says The Fund Library’s new system differs dramatically from others, in that it discounts past performance and focuses on the costs involved in individual funds. The system looks at the MER and the turnover rate of equity holdings to assess the costs the fund, reasoning that the lower the costs borne by investors, the higher the real return should be.

“I wanted to find some indicators that would be more predictive in value. Over the past two or three years, it has been highlighted that management fees are an important part of returns,” says Folk. “If you look at the MER on a mutual fund, if you have high fees, that’s going to be a drag on performance. It doesn’t necessarily mean that the fund is going to have below average performance, but there’s a better chance that it will.”

Folk says he studied a cross-section of Canadian equity funds and found that those with the higher MERs did in fact have lower performance, on average, over the long term.

He also looked at the turnover rate of the funds’ portfolios, since high turnover can result in higher trading costs incurred by the fund.

“The more that stocks and bonds are bought and sold, the more trading commissions associated with those purchases and sales will be,” Folk says. “Funds with high turnover, one would suspect, will have lower returns on average across any individual fund category.”

In an informal study, Folk also found that buy-and-hold managers outperformed their more active counterparts throughout the bear market. He found superior performance in not just the value managers, where such strategy is more strongly entrenched, but also in growth managers that adopted the buy-and-hold approach.

To back up this finding, he dug up the turnover data for various Canadian equity funds and compared their performance on this basis, also taking into account their MER.

“There was a strong statistical relationship between turnover and MER and long term returns,” he says. “It takes some time for the MER to show up in returns. The more money taken off the table through the MER; that will compound over several years and it will eventually hit returns over the long term.”

It may take five or 10 years for a higher MER to show up in lower returns, because there’s a compounding effect there as well.

Of course, investors should never base a decision simply on a single ratings system, which Folk readily points out. He also admits the new ratings system has its shortcomings, such as discounting a fund manager’s skill. The Fund Library’s ratings are essentially a measure of drag on fund performance. And he says the traditional ratings systems do offer insight into the risk level involved in a rated fund.

“I think it’s really important for investors who are just starting out. I think it’s a much better place to start than the other ratings systems that tell you how a fund performed in the past,” Folk says. “There’s no guarantee that if you buy a fund with high turnover and a high MER that it’s not going to do well, there are some that have, but it is a greater drag on the fund’s performance, so the manager has to be that much better to beat that over the long term.”

Filed by Steven Lamb, Advisor.ca, steven.lamb@advisor.rogers.com

(08/23/04)

Steven Lamb