Ever wondered what the difference between a ‘Highly Recommended’ and a ‘Five Star’ fund is? Find out below how research houses determine a managed fund’s rating, what they really mean and why they are useful when deciding which fund to choose.

Managed fund ratings first popped up in Australia in the late 1990s. In fact Morningstar, a US-based research house, was the first to introduce ratings here in April 1998. Since then a number of research houses have entered the domestic market, including Standard & Poor’s, Lonsec and van Eyk.

The emergence of research houses coincided with the overwhelming growth in the Australian funds management industry over the past ten years. As that industry grew, so too did the number of investment products available, which in turn fuelled the need for someone to separate the good funds from the bad.

How are funds rated?

There is no single strategy used across the Australian research industry to determine a fund’s rating. Rather, each research house develops and applies its own unique ratings methodology, using either quantitative analysis or qualitative analysis or a combination of both to determine a fund’s rating. You can think of quantitative analysis as the study of hard data, e.g. historical performance figures. Qualitative analysis on the other hand refers to the study of things like management teams, investment styles and risk controls. This type of data is generally gathered through face-to-face interviews with the people involved with the fund.

When assessing a fund’s overall rating, Australian research houses tend to lean towards qualitative components whereas houses in the US tend to focus more on quantitative analysis.

What do ratings mean?

The other way research houses tend to differentiate themselves is the way they articulate those ratings to investors. For example, Morningstar and Standard & Poor’s use star images whereas Lonsec and van Eyk use letters of the alphabet.

So what’s the difference between Standard & Poor’s ‘Five Stars’ rating and Lonsec’s ‘Highly Recommended’ rating? Essentially there is no difference. Both are the highest rating that each research house can give a fund. They are just different ways of articulating the same message, which is that both research houses have high conviction that the fund in question will perform well relative to its investment objectives and its peers.

Are ratings useful?

Ratings are useful insofar as they provide valuable insight into the workings and performance of a managed fund. However, strong ratings don’t always translate to strong investment performance, which means they should only be considered as part of an overall investment strategy when deciding where you should invest.