The Myth of Fund Ratings


Note: This article was originally published on July 26, 2005. Since it was so popular, we decided to reissue it for our new visitors to IFA.com. The author told me this story and I asked him to write it down and submit to our article section. He preferred to be anonymous, but we do have his name on file. Enjoy, Mark Hebner

“And that's how we rate mutual funds. Any questions?” the teacher asked. My hand shot up immediately. I had been recently hired by a popular investment advisory company. While undergoing their training process, I was exposed to their faulty methodologies. They claimed to put investors first and I joined the firm for precisely that reason. But after a short period of time, I realized that their interest in helping investors was little more than a beautifully constructed façade.

I almost felt sorry for the teacher who had explained the company's fund rating methodology. He wasn't a manager or senior executive. He was just a regular employee who volunteered to teach the new hires. But one thing turned me flat out against him. A fellow new hire asked how well the fund ratings correlated with future returns. (In the interest of protecting the teacher's identity, let's call him Hermes.) Hermes responded, “Our users use it as if it was a predictive measure, but they do not correlate with future returns…and we never claim they do. We put it in the fine print at the bottom of the page that they do not predict future returns. Naturally, when we're trying to pitch the rating system—well, we try not to mention that fact.” He laughed at his own humorless joke. Now, I felt no remorse. Now, I was no longer killing the messenger—he was an actor. He was a participant. And he found it funny that literally millions of investors used this rating system to their own detriment.

Finally, he called on me. I smiled a little bit. He didn't know what he had coming. I had read several academic research papers examining our mutual fund rating system. All had shown it was a completely useless measure. And now, after seeing what it was based on—risk-adjusted returns against peers in arbitrarily chosen investment categories after literally dozens of studies have shown that a fund's returns are uncorrelated from period to period—I was ready to roll over this guy.

“How can we use this measure that has been shown to deliver no value and effectively advertise funds that will end up destroying value for their investors? It's useless.” I was being kind. It was not just useless. Something that destroys investors' savings while lining the pockets of investment professionals is not simply useless but downright unethical. Hermes replied, “Well…I wouldn't say it's useless. We don't claim it predicts future returns. If investors misuse it, we can't do anything about that. It's just a starting point.” I could've responded, but the eyes of the fourteen other new hires were all on me. I had already made a scene, so I just kept my mouth shut.

After the class, the woman who organized the classes spoke with me. She gave me two choices: stop asking questions or stop going to the classes and go back to work. I chose the latter. I immediately went to both my immediate supervisor and my boss to tell them what happened. They said my conduct was wrong and that I shouldn't question the methodology. I said that what I did was right and refused to apologize. They sent me back to my cubicle to work, but I wasn't about to give it up.

The next week, I set up a meeting with my boss. Let's call him Sisyphus. Before meeting with him, I told a co-worker and friend what I was about to do. I told him I intended to challenge the system on the grounds that it hurt investors. He admired my courage but told me that I was playing a dangerous game. “The people who last here know how to play office politics, and that's just an unfortunate fact.” “I don't play politics. I do what's right for the investors.” “Fine…just don't get fired.” “I'd rather get fired than stand down.”

I left my friend and walked up to my boss's desk. I jumped right into my argument. I told him that our mutual fund rating methodology was misleading. Our highest rated funds received huge cash inflows while our lower rated funds received cash outflows. We were a widely regarded firm, so I doubted this could simply be because our rating system was mostly performance based. Overall, our methodology was shown to be pretty mediocre. Sisyphus, of course, disagreed, replying simply, “It is a good starting point.” I asked angrily, “How can it be a good starting point if it does not predict future returns?” I spat out a thousand proven facts. At least 80% of actively managed funds underperform the S&P 500 in any 10 year period—and there are indexes that perform better than the S&P 500. If risk-adjusted returns are taken into account, funds lose out even more. Fund returns are uncorrelated, so distinguishing luck and skill is impossible. Not only is the rating system not a cure all, it's not even a meaningful starting point. He replied naively, “People enjoy the act of searching for funds. If they have to pay thirty basis points to enjoy the act of finding an actively managed mutual fund, that's fine. Hey, people pay for skiing.” I was floored. People pay for skiing. Apparently, the act of choosing an actively fund that loses out to an index fund is akin to skiing—highly enjoyable but with an acceptable price. And clearly, they were losing significantly more than 30 basis points, an unfortunate fact of which Sisyphus seemed quite ignorant.

I was told to get back to work, which I did, notably disillusioned from my experiences. An hour later, Sisyphus took me aside and told me that my employment was terminated. Of course, I expected it. But it was worth it. I asked briefly why I was getting fired. “You are very argumentative. This is something you should probably fix.” I nodded as I got up and left the office—one burden less on my conscience.

Vivek Viswanathan