It's all in the stars - or is it?

Published: Wed 28 Nov 2001 05:51 PM
It's all in the stars - or is it?
The Australasian Managing Director of Frank Russell Company, Alan Schoenheimer, has warned investors and financial planners that the star rating of a fund appears to have a slight correlation with its past performance, no clear correlation with its future performance, and should not be the sole basis for investment decision-making.
Speaking at the Australian Financial Planners Conference in Brisbane on Saturday, Mr Schoenheimer presented the results of Russell's analysis, which tested the effectiveness of star ratings. Mr Schoenheimer said that with the increased availability of ratings information on the internet and the current focus on star ratings in the marketing and advertising of managed funds, it was important that investors understood what star ratings systems could or could not do, and their limitations.
"Star ratings are used to market many products and services - from movies to holidays to restaurants. They are eye-catching and powerful marketing tools, I can understand their attraction to managers and investors alike", he said.
"However, the consequences of relying solely on star ratings for making a decision on a future investment are just too great." Frank Russell Company spends over NZ$25 million globally each year on research into managed funds, and was concerned that too much emphasis is placed on star ratings at the expense of other, more in-depth and qualitative, measures of performance.
The study is the first to analyse retail managed funds investing in Australian equities, international equities and fixed income, and to measure performance against star ratings. It uses data from Morningstar, which was chosen because its process is more transparent than other rating agencies.
Russell's analysis found that unlike the United States, where significant cash flow occurs between funds as a result of re-ratings, the Australian market is driven more by the power of distribution networks - particularly the big banks - than changes in ratings. In fact, the Russell analysis found that some of the highest cash inflows in 2000 were into funds not rated.
The Russell analysis also looked at the relationship between star ratings and immediate past performance, and found that there was a slight correlation between the two. "If a fund has a high star ranking today, it is likely to have performed well in the previous twelve months", Mr Schoenheimer said.
However, the Russell analysis revealed that star ratings' ability to predict future performance was much less clear. "If you buy a five star - ranked fund today, don't bet on it delivering you a five star return in a year's time", concluded Mr Schoenheimer.
Mr Schoenheimer also pointed out that investors should look carefully at what drives performance ratings. For example, in order to place in the top 10% of a fund category - earning a five-star rating - a fund manager may take on high levels of risk. That risk is often inappropriate for many investors, and may land the fund among the bottom performers the following year.
"There is also no mention of the manager's style", Mr Schoenheimer continued. "Russell's research shows styles - like growth or value - move in and out of favour with the market. When growth-stock investing falls out of fashion, as it does from time to time, all those growth funds will stall together. One should not pick a fund on the star rating alone, without considering the fund's investment style." Mr Schoenheimer concluded that: * Star rating of a fund appears to have a slight correlation with its past performance * Star ratings are not a reliable predictor of future short-term performance, * For the moment at least, the money is not chasing the stars, and * Star ratings themselves do not address the issue of style, * Investors should pay more attention to the stars (key staff managing the portfolio) within their funds.
Frank Russell Company, a global investment services firm, provides multi-manager investment products and services in more than 35 countries, and has been researching money managers for more than 30 years.
Worldwide, Russell manages over NZ$149 billion in assets and advises clients representing approximately NZ$3.0 trillion worldwide. In New Zealand, Frank Russell Company (N.Z.) Limited advises on more than NZ$14 billion in assets, and invests around NZ$1.3 billion for New Zealand investors in Russell Funds. Founded in 1936, Russell is a subsidiary of Northwestern Mutual and is headquartered in Tacoma, Washington, USA with additional offices in New York, Toronto, London, Paris, Amsterdam, Singapore, Sydney, Auckland, Tokyo and Johannesburg. For more information visit For a relevant investment statement, please call (09) 357 6633.
Frank Russell Company, a Washington, USA Corporation, operates through subsidiaries worldwide. This news release is issued by Russell Investment Management Ltd ABN 53 068 338 974.
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