Do not be fooled by fund rankings

London: To the extent that good can come from calamity, the silver lining of the credit crunch is that it has begat an era of more cautious lending, tougher capital rules and wider regulation, plus more risk-aware investment processes. The crisis was so searing that its lessons will be carried by a whole generation of finance professionals.

It is not the fading of human memories that should worry us most. It is a fading of statistical memory.

As we have checked off the string of “fifth anniversaries” of credit crisis milestones, the period is being erased from some of the most important metrics used by investors to plan their portfolios — with the result that the risks in those portfolios may be unwittingly drifting upwards.

An arresting piece of analysis by Markov Processes International, a research group, shows that some of the mutual funds that performed terribly for their investors during the crisis are suddenly looking much healthier on a five-year view, while a number of the most conservative funds that weathered the storm best have tumbled down the rankings.

The upheaval in the five-year performance table is striking. Using the widely-followed risk-adjusted return measure promulgated by Morningstar, the proportion of large cap equity funds shifting at least 10 percentage places up or down the rankings in any given month has jumped sharply, according to MPI.

Typically, fewer than one in 10 funds move by more than one decile in the rankings from month to month. Since September of last year, such big moves have been between two and four times more likely. Many funds have shifted by two deciles, meaning conservative funds that ranked 20th out of 100 might suddenly find themselves ranked 40th or worse.

The moves are the more striking because they occur even in supposedly risk-adjusted performance tables.

Take the $6bn Invesco Charter fund, for example. It describes itself as a “conservative cornerstone” for an investor’s portfolio and boasts large defensive holdings in American Express and big pharma companies. Using another risk-adjusted measure popular among consultants called the Sortino ratio, MPI finds Invesco has sunk quickly from the top 10 per cent of large-cap equity funds to the bottom half of the pack as its 2008 performance has faded from the numbers.

Regulators can insist upon warnings that past performance is no guide to future returns, but these performance tables remain central to the decision making of both institutional and retail investors.

It is not just Bill Gross’s terrible recent performance that has pushed his Pimco Total Return bond fund down the five-year league tables, but the absence of his notable run through the credit crisis, when he adopted a defensive crouch in US Treasuries well before his rivals saw the likely effects of the housing market blow-up. BlackRock, meanwhile, has been patiently waiting for the anniversary of the crisis to pass and is now loudly marketing the strong five-year track record of its reconstituted bond investment division.

Morningstar’s star ratings have a particularly profound effect on flows in and out of mutual funds, and its five-year ranking accounts for 30 per cent of its overall star rating, which runs from one to five stars. For funds that do not yet have a 10-year track record, they account for 60 per cent of the rating.

The consequences can be alarming, as Morningstar itself notes (although it places at least some of the blame on human nature and television business news rather than its own power). Investors routinely pick the worst times to move in and out of funds, piling into bonds funds for example in 2012 on the eve of the first down year for the asset class since 1999.

The average mutual fund was up 7.3 per cent over the 10 years to the end of 2013 but the average mutual fund investor was up just 4.8 per cent because of poorly-timed moves between funds, according to an analysis by Morningstar.

Performance-chasing explains the disconnect, but the risks that this inevitable human bias adds to portfolios are being compounded by the loss of statistical memory of the credit crisis. After five years of benign markets, investors are losing valuable insights into how funds may perform if volatility and asset price declines return — a scenario that is increasingly likely.

One of the lessons of the credit crisis is that investors have a responsibility to examine the methodologies and the assumptions underlying the rankings of the financial products they use. That is as true in mutual fund ratings as it ever was in credit ratings.

— Financial Times