FT Fund Ratings produces information on funds in three areas: -- Risk, Charges and Performance.
Risk
Risk Profile
The Risk Profile is the foundation of FT Fund Ratings. All of the other data about the risk of a fund is either derived from it, summarised by it or a qualification of it. It plays a fundamental role in the calculation of the Performance rating.
The aim of the Risk Profile is to identify funds that exhibit a certain kind of behaviour and also to describe that behaviour.
Our approach uses a description of the risk of the fund provided to us by Advanced Portfolio Technologies ("APT"). Guided by the well-established Arbitrage Pricing Theory, APT determines twenty distinct and independent factors intended to determine the behaviour of the market. This is done by an analysis of the movements of approximately 50,000 share, bond, commodity and currency prices from all over the world over a 180 week period. The twenty factors are determined mathematically and change from month to month.
Once these factors have been calculated, the exposure of each fund to each of the factors is estimated. This is like finding the co-ordinates of each fund on a map but in twenty dimensions. In particular it becomes possible to determine a "distance" between each fund in terms of the difference between their estimated exposures. This distance is a measurement of how much the values of two funds have been likely to diverge from one another sometimes known as the "tracking error", especially where one of the funds is an index.
Risk Profiles are calculated by finding co-ordinates that approximate those of a group of funds that have demonstrated similar behaviour. The calculation takes over a week of computer time.
Once the co-ordinates of the Risk Profiles have been identified, each fund is assigned to the Risk Profile nearest to the fund.
Funds that share a Risk Profile have by definition displayed fairly similar behaviour. There is no a priori reason why they should prove to be similar in other ways but we regard it as a confirmation of the approach that on inspection the groups of funds assigned the same Risk Profile display similarities that are intelligible without the help of the grouping. Risk Profiles are named according to the funds identified with them and also consideration of the Risk Attributions described below.
Risk Profiles are not recalculated every month. Either every three months or (if sooner) when the behaviour of the market changes enough to throw doubt upon the accuracy of the assignments we recalculate the Risk Profiles from scratch. In between we recalculate all the distances and adjustments.
Risk Profiles are not dependent upon currency. Similar behaviour is not dependent upon the denomination used to observe it.
Match Rating
From the description above it is clear that the approximation of the behaviour of each fund by its Risk Profile is not the same for each fund. The purpose of the Match Rating is to measure the quality of the approximation. To calculate the rating, all funds that share a Risk Profile are ranked by their distance from the Risk Profile. The 20 per cent nearest to the Risk Profile are given a Match Rating of 5 or Very High, the next 20 per cent a 4 or High and so on. Those with a Match Rating of 1 or Very Low are the least well described by their Risk Profile.
Risk Level
In general there will be between 50 and 60 different Risk Profiles. To distinguish between them we have divided them into Risk Levels corresponding to the average volatility of the funds with that Risk Profile. Volatility is a measure of the unpredictability of the value of a share. Funds with high volatility present high risks. The link between low volatility and low risk is not direct. It depends upon the purpose of the investment, the investor's other investments and the precise nature of the investment. These factors are vital and may not be reflected in the volatility of the price.
The Risk Level rating is on a scale from 1, very low to 5, very high. Ratings are allocated according to the position of the average volatility on a scale. The divisions on the scale are arranged so that apart from the extremes the ratio between the upper and lower limits is always the same. In general there is no reason to expect the distribution of Risk Profiles to be even and in general most funds will be given a high rating.
Risk Attributions
The analysis of risk provided by APT contains a lot of information. The role of Risk Attributions is to express it in a comprehensible way.
Two methods are employed to do this.
The simpler method, Risk Sensitivity, measures the historical relationship between movements in a single indicator such as a well known equity index like the FTSE-100. The figure represents the relative size and direction of the move in the price of a fund that on average accompanies a movement in the indicator. For example if the FTSE 100 moves from 5000 to 5050 and the fund or risk profile has a sensitivity of 125 per cent, all else being equal, on average, we would expect the fund to rise by 1.25 per cent. Of course usually all will not be equal and the movement will not be average. The second method, Risk Allocation, produces information in the form of a portfolio asset allocation. The risks of a family of indices are mapped to the same space as the funds. An optimisation algorithm is then used to determine what combination of these indices most closely matches the risk exposure of the fund or Risk Profile in question. The result is the portfolio of indexed investments which approximates the risk of the fund or Risk Profile.
Geographic
This is the Risk Allocation determined by a family of indices determined by geographical exposure. The indices are from FTSE International's World series. The equivalent statistics for the FTSE All-Share Index are provided for comparison.
Industry
This is the Risk Allocation determined by a family of indices determined by industry exposure. The indices are divided by their FTSE Actuaries Industry Sector. The equivalent statistics for the FTSE All-Share Index are provided for comparison.
Economic Factors
We calculate the Risk Sensitivities of the fund or Risk Profile in question to various equity indices and other Economic indicators.
Fundamentals
We calculate five risk allocations according to indices defined by fundamental valuation criteria. Risk is distributed between, for example its market capitalisation - whether it is a large or small company - or the ratio between the value of its assets and its market value - whether it is a growth or value stock. This data may be useful for identifying the investment style of a fund.
Data Quality
In some cases we do not have sufficient data to determine the above statistics. For instance if the value of the fund is only calculated quarterly or the fund is very new. If this is the case we will not provide data for it.
In some cases there may seem to be sufficient data but we are aware that we have not properly captured the behaviour of a fund. In that case we will still calculate Risk Attributions but not a Risk Profile, Match Rating or Risk Level.
Charges
Our Charge ratings are based on the Total Expense Ratios calculated by Fitzrovia. These are a measure of the proportion of the value of a fund taken in fees over a year. These fees are usually dominated by the annual management charge, usually a fixed proportion of the value of a fund. On top of the annual management fee there are other fees for administration and registration of the fund that may not depend upon the size of the fund. The effects of these charges are compared to the average value of the fund over a year and combined with proportional costs to produce a ratio expressing the charges levied for the service of managing the fund.
Two important expenses are omitted in this calculation - initial and terminal charges. They are significant but their importance depends upon the duration of the investment and varies even for the same fund depending upon where you buy the fund. Also not included are trading costs. This is due to a lack of information and investors must rely on performance figures to measure their impact. All ratings are compiled from statutory audited data. Some types of fund not directly available to the public are not obliged to publish the necessary data. These funds may nevertheless feature in pension funds or life policies and unfortunately we are unable to provide a Total Expense Ratio for them. There are also some cases where we can provide a Total Expense Ratio but do not use it to provide a charge rating. The typical reason for this is when the fund is a fund of funds. In this case the TER accurately reflects the charges levied directly by the fund but not those levied by its investments. In this case the TER is fair but not comparable with other funds.
The ratings are applied on the following basis.
| Total Expense Ratio | Rating | |||||||||||
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Performance
The aim of the performance rating is, as far as possible, to compare like with like. To this end all comparisons are only between funds with the same Risk Profile. Performance is compared after being adjusted for exposure to the risk factor defined by the Risk Profile. The adjusted performance is calculated in the following way:
Calculate beta, the ratio between the Risk Profile of the fund and its exposure to the risk factor the profile determines
Take the 180 week total return
Remove the 180 week risk free rate of return
Divide by beta
Restore the risk free rate of return
This method is an extension of the Modigliani and Modigliani risk adjustment. It differs by its use of our more specific risk adjustment.
The risk free rate depends upon the currency but for Sterling Ratings it is determined by the weekly return given by the weekly London interbank lending rate (LIBOR). Ratings are then determined by quintile of performance with the top twenty per cent getting a very high rating and the bottom a very low rating.
Data Quality
To calculate this rating we must have, in addition to the relevant risk information, the 180 week performance figure. We do not wish to compare the performances of funds over different periods. That means that we will not produce a rating for a fund which is less than 180 weeks old.
Scope of the ratings
Range of Funds Compared
We compare all funds from the following markets for which we can obtain appropriate data:
UK
Offshore
Germany
France
Italy
Spain
Sweden
Austria
Ireland
We expect this range to increase over time.
Limitations of Risk Measurement
All risk information is based upon the movement of price histories. That provides information about a major part of the risk of the fund but there are limitations on the scope of this information.
The information depends upon risks being reflected in share price movements. In some classes of funds that is not necessarily the case. Some property funds, venture capital funds and special share classes of split capital investment trusts fall into this category.
Some risks will not necessarily show up in the price movement of funds. Risks not directly connected with the capital markets, the solvency of the manager or the possibility of fraud for example are not taken into account.
Occasionally funds are closed or merge and sometimes they change strategy. When this comes to our attention we only consider movements after the change.
Currency Dependence
FT Fund Ratings produces fund information based in several different currencies. It is a feature of these ratings that some of the ratings remain the same regardless of the currency used. The Risk Profile and Match Rating and Charge Rating do not depend upon currency. Volatility Level, some Risk Attributions, Risk Adjusted Performance and Performance Ratings however do all depend upon the currency.