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Advisers challenged by starry-eyed investors

Advisers should take steps to help end their clients’ over-reliance on star ratings of funds and fund managers, says Russell Investments.

Research recently released by Russell Investments indicates that star ratings issued by agencies like Morningstar and Lipper are disproportionately relied on by retail investors in developing perceptions of fund performance. 

The research showed that in 2012 in the US market, $390 billion was invested in 4- and 5-star funds, while 1-, 2- and 3-star funds “experienced net outflows as groups”.

“Retail investors are naturally attracted to the ‘rock star’ funds,” Russell Investments director of client investment strategies, Scott Fletcher, told ifa.

“In our opinion, stars can be helpful in giving general information about the quality of a fund but as a predictor of future performance, the evidence suggests it is negatively-correlated overseas and zero-correlated in Australia,” he said.

While many advisers are able to accurately analyse ratings, the strong preference of clients for star-rated funds can be a significant “challenge for advisers”, Fletcher said.

Advisers should play an active role in helping clients to get over their predilection for star ratings and provide them with more accurate information about what ratings mean and how to measure performance, he added.

“Advisers need to have a more long-term strategic discussion with clients about investment goals,” Fletcher said. “This approach will help to take investors away from short-term reliance on star ratings and what’s happening this week, last month, next month.”

However, even advisers are not immune to placing a disproportionate weight on ratings.

“Advisers need to have a skill set in determining what managers will perform for them, but if they don’t have that they have nothing to go off except the ratings,” Fletcher said.