Fund manager ratings: why due diligence is key, even on ratings houses

Research reports should provide key technical and compliance information on the fund, and insights into the operational aspects of both the management company and the fund. In addition to covering both the fund’s strategy and investment objectives, the research should include in depth due diligence, and verification of the management company, as well as the people behind the fund including their experience, track record, stability, and alignment of interest of the fund's investment team.

It goes without saying there should in-depth investigation of any real or potential conflicts of interest, and verification of any claims made by the manager, as occurs when a company is listed on the ASX.

One of the most important aspects of a research report is the fund’s current and past performance history to enable the reader to check that the expectation of return and risk – although never a promise – matches reality. Unfortunately, this is frequently either lacking full clarity and analysis, or is out of date, or is covered by the regular disclaimer line “past performance is no guarantee…”

Above everything else a fund manager’s past performance is essential. While every investment will, or should, come with the “past performance” warning, without looking at a fund or manager’s track record, what else is there to judge them by?

There are varying thoughts about the ideal length of track record you should look for, and it will vary on asset type and your personal circumstances. Most offer documents will suggest at least five or seven years to ensure you can see across multiple time frames and different market conditions. Although this doesn’t guarantee future performance, you will see the manager’s track record.

Yet, in Shield’s case, the fund still had a rating from SQM Research.

SQM had given Shield and First Guardian a “favourable” 3.75 stars out of 5, before downgrading them shortly before investor withdrawals were frozen. This rating was given despite the funds having no track record, and it transpires significant conflicts of interest, which proper due diligence or verification should have uncovered.

ASIC is going to hold all links in the Shield and First Guardian chain accountable, which highlights that research reports and their ratings can’t necessarily be relied upon by advisers, dealer groups, platforms and trustees. As such, they each need to conduct their own research and due diligence.

Which of course begs the question – especially when there’s a fund failure – why didn’t they?

For the end investor the issue is compounded further by the fact that the report is rarely available to them. Instead, they are just presented with the rating itself or rely on their adviser - which they should be able to do.

There’s no guarantee that the rating reflects reality as the rating itself is often taken as gospel, without examining the fund, and without doing their own research, which generally they’re not sufficiently equipped to do.

This covers a generic industry issue which is going to impact the good and honest players (the majority) as well as those at fault – the so called “bad actors” who in the financial services sector seem to occur with monotonous regularity.

In this case, as well as there being a structural problem, the investigation to date suggests that bad actors lured potential investors via false comparison websites, who were then called by lead generators and referred to financial advice providers, who in turn advised investors to roll their superannuation assets into Shield or First Guardian.

ASIC is continuing to investigate misconduct relating to the Shield and First Guardian Master Funds to hold those involved to account. However, it is likely that ratings houses are here to stay. If that is the case there needs to be change, and greater transparency, or investors will need to conduct their own due diligence on both the ratings houses and fund managers themselves which of course they are ill equipped to do without the financial knowledge, or the fund’s track record to go on.

It may be awkward to ask, who pays for a fund manager rating? Does the research house charge advisers, investors or platforms, or continue to charge the fund manager for the rating or subsequent services?

There is a good argument for changing the current system from the manager paying for the rating, to a process where the investor, adviser or platform pays for it. Apart from the removal of a potential conflict of interest, that would add to the transparency of the ratings process.

However, that risks the situation where the there is no research as no one wants to pay for something they aren’t forced to have - even if logic and common sense suggest they should.

Maybe ASIC will legislate a solution. Or maybe the advice and platform industry will decide the cost of accepting research commissioned by the fund manager is not worth the risk.

In the meantime, while the only way for a fund manager to tick the box and pay for a research report and rating, the status quo is likely to continue.

Chris Gosselin, CEO of Fundmonitors.com.