Reaching For The Stars With The Mutuals

US mutual fund companies are not selling packaged investments any more - they are selling stars. That, at least is the way many fund managers feel about the increasing dominance of performance measurement agencies.

These are lead by Morningstar, of Chicago, with its system of classifying funds into five star categories. Mornigstars rival, the New York-based Lipper Analytical, provides a wide range of rankings over various periods. Its service is quoted widely in the media and is also used generally by brokers, and in advertising.

Standard and Poors, one of Wall Streets most powerful debt rating agencies, intends to enter the market later this year. Its approach employs both quantitative criteria and the judgements of individual analysts, who interview managers of strongly-performing funds. With their wide currency, ratings are growing in subtlety and are becoming essential to fund sales. Smaller companies, in particular, emphasise them in advertising.

 

Lawrence Kash, a director of Dreyfus, which is a large asset manager owned by the Mellon Bank of Pittsburgh, explains: We are a society of credentials, and those credentials are now being applied to us by a third party. Investors dont trust anyone other than Morningstar.

He suggests that the wide availability of independent performance measures has helped to conquer investors distrust and expand the market for mutual funds. Moreover, it has allowed distribution channels to proliferate.

The impact of performance measures can be clearly seen in sales figures, with funds with strong ratings regularly boosting their sales. PBHG, a small manager which specialises in aggressive growth investment in small-capitalisation stocks, managed total assets of $2.9 bn at the beginning of last year.But after its flagship fund featured at the top of Lippers ratings over both five and ten years in mid-year, it took in a deluge of new money. The final tally for 1996 was $6.6 bn.

Equally spectacular was the way money soon began to flow out of Fidelitys Magellan fund, the largest in the industry, when its performance dipped badly last year. While the fund continued to grow strongly in absolute terms, thanks to the bull market in US equities, and to log phenomenal performance when examined over long time periods, its one-year performance was horrible at one point, it ranked 590th out of 628 US growth funds, according to Lipper.

And, while the rest of the industry has boomed, Magellan has recorded net outflows of funds for 14 consecutive months.

All this power has concentrated attention on the perverse side-effects of the ranking systems. Morningstars system, adopted originally as a useful guide to reading through its reams of statistical information, might now be given too much weight when investors make decisions.

The system is deliberately broad and general, with no ratings available for funds which have not been in business for at least three years. The top 10 per cent receive five stars, the next 22.5 per cent get four, and the middle 35 per cent are awarded three.

There is no such thing as a no-star fund barring those which are less than three years old. The bottom 10 per cent are awarded one star. But funds with five and four stars, which make up slightly less than a third of all funds on offer, account for about 80 per cent of all new money being invested.

This suggests that performance has been commoditised, to borrow a term from investment bank Goldman Sachs. In other words, consumers make sure that a fund has a certain star rating and are not concerned to delve deeper.

Morningstar goes to great lengths to be fair. Its system is based on a funds return over three years following the deduction of both its sales load, and the risk-free return that could have been earned by investing in 90-day treasury bills.

Morningstar then subtracts the funds risk score which, controversially, focuses only on downside risk. This measures how many months a fund underperforms 90-day treasury bills compared with others in its sectors.

According to Morningstar, the big fear for most investors is losing money, so the risk measure does not take account of periods of volatile overperformance. This is a good, simplified basis which investors can use to start looking for funds. Now, though, the industry is beginning to spot problems.

First, Morningstar breaks funds into only four categories: equity, taxable bond, municipal bond, and hybrid. The result is that funds investing in different countries or different sectors of the United States economy, are compared directly.

This creates anomalies. There are not many five-star Japanese funds, for example, while bond funds are dominated by high yield or junk bond funds which have fared well recently in spite of being relatively high risk.

Some managers dislike the risk measure. They believe it fails to penalise erratic funds which, occasionally, show big outperformance.

Attempts by companies to find their way around the refusal to rate funds with a history of less than three years is creating tension. Some are said to launch funds but not to open them to the public for three years, quietly closing those with poor performance.

Meanwhile, many large institutional fund managers are taking existing funds and opening them to mutual fund investors.

The impact can be clearly seen in sales figures, with funds with strong ratings regularly boosting their sales.