Reaching for Stars

October 2010, Business2Business

Five star ratings don't always lead to five star investments.

Investors often seek external validation to ease the anxiety of putting their money at risk, however the problem is there is no guarantee that a "five-star" rating on a chosen fund will lead to a "five-star" investment experience.

It’s human nature for consumers to seek comfort in the idea that the products they are buying are proven in the marketplace. That need is met by ratings agencies who play a legitimate and vital role in providing independent assessments of various investment products.

These assessments can be a useful measurement for investors when comparing funds and to assist with making a fully informed decision, however they should not be the sole measurement tool. Problems arise when investors blindly extrapolate star rating systems for various funds into imagined future performance, despite diligent cautions from the agencies about chasing returns.

There is a large body of academic evidence that shows it is extremely difficult to predict market returns with any confidence and that past returns should not be the foundation for choosing one fund over another. In fact there’s usually a good chance they have become overpriced and will perform worse than average.

This is confirmed by our own research and the funds we invest in. For example, in 2008, the best performer was NZ Government Bond providing a return of 15.85%, yet this was the worst performer for 2009 providing a return of only 1.63%. Conversely, Australian Small was the best performer in 2009 providing a phenomenal return of 70.21%, but had been the worst performer for 2008 with a return of - 45.17%

So, what do you need to weigh up when making a decision? The key is to focus on things within your control:

• Are the risks being taken related to return?
• Are those risks targeted in a reliable, consistent way?
• How diversified is the fund?
• Does it make promises it can't keep?
• Are the underlying strategies driven by forecasts?
• Does the fund take account the costs and taxes in its decisions?
• Does the fund manager communicate in a clear and consistent way?

While many of these attributes can lead to good outcomes for investors, they are no guarantee of positive returns every year. They can however provide investors with comfort that their money is being invested in a consistent, transparent way and ensures that when the targeted returns kick in, they are positioned to receive them.

This is a grounded and sensible approach, as reaching for the stars may leave investors clutching at straws.