Isn’t it true that modern society loves a ‘star rating’?
Most of us know what to expect if we book a 5-star hotel stay for a business trip when compared to a 3-star bed-and-breakfast for a weekend away.
The investment field is no different, with many institutions offering their own spin on star ratings and how to calculate them.
However, unlike the hotel industry, I would suggest many of the rating systems that assess the funds used by investors are best ignored.
Let’s investigate why this might be the case…
A quick Google of a fund name will most likely return links to some of the major data providers out there such as Trustnet, Morningstar, and The Financial Times. For instance, I recently came across a UK Equity Fund that is currently rated as 5 Crowns on Trustnet through a system calculated by Financial Express – I won’t however mention the fund as I wouldn’t want anyone to consider this as a recommendation!
On these pages one might find star ratings, or similar, implying the relative quality of a product.
But, the challenge with these types of ratings is that the focus is solely on recent, short-term performance as opposed to long-term, sensible structure.
Without getting too granular, the Crown Ratings are derived using 3-year performance and volatility – in other words, how much the performance moves up and down compared to a benchmark, such as the FTSE 100 Index aka the Footsie 100 Index.
The thing is, 3 years is not nearly enough time, nor is the sole use of performance figures insightful enough, to properly test the efficacy of a fund’s strategy or test the ability of the fund manager to pick shares or time markets.
In any case, remember that picking shares and timing the markets is not a game played by sensible, systematic investors!
Reviewing a track record of 20 years would be statistically more prudent, however, to have benefited as an investor one would have had to identify the investment in advance which is nigh impossible.
As Frederick the Great once said, “A crown is merely a hat that lets the rain in”!
At Wells Gibson, we believe strongly that structuring portfolios based on ratings that are derived with hindsight goggles is a dangerous game.
However, sadly, there are many investors out there that do pay attention to these ratings and are engaged in a repetitive cycle of buying high and selling low.
For more information please get in touch with the Wells Gibson team.