How Defaqto rates funds

Patrick Norwood – Insight Analyst (Funds)

In the previous Multi-Asset Funds Newsletter we talked about Defaqto’s Diamond Ratings, why advisers and networks use them, and we gave an overview of how we rate funds and fund families. Following on from this, I now go through the ratings process in a bit more detail in this article.

Just to recap, when rating funds we initially separate them into a number of ‘universes’, so that we can compare like with like. Also, with return focused and passive, we rate at the fund level, whereas with risk targeted and risk focused, we consider and compare funds as ‘families’.

Analysing return focused funds

At Defaqto we split the return focused universe further, firstly by whether funds are single or multi-manager and secondly into four different Investment Association sectors, which creates eight sub-universes.

Within each of these sub-universes the funds are ranked and scored on each of the following criteria:

• Sharpe Ratio, a risk-adjusted performance measure
• QuantRater, our own internal performance measure
• Ongoing charges figure (OCF)
• Fund manager tenure
• Number of distribution partners (which we see as a measure of accessibility)
• Fund and group assets under management (with the latter being a good proxy for resources available to the fund manager)
• UCITS compliance and domicile of the fund
• Return on any stock lending – single-manager funds only

The two performance measures each receive a double weighting, with the result that the fund’s performance drives roughly a third of its overall Diamond Rating.

Analysing risk targeted/risk focused fund families

We have created a synthetic universe for risk targeted/risk focused fund families, with the funds in the families being found across various Investment Association sectors.

Families are ranked and scored on each of the following:

• Sharpe Ratio
• Shape, Consistency and Spread, our own internal ‘risk shape’ measures for the family (more about this in the recent article on taking risk shape into account)
• Number of funds in the family (a greater number means that advisers can more closely align a fund’s objectives to the needs of a particular client)
• OCF
• Fund manager tenure
• Number of distribution partners
• Family assets under management
• UCITS compliance and domicile

The Sharpe Ratio and three risk shape measures each receive a double weighting, with the result that the family’s return and risk characteristics comprise just over half of the overall Diamond Rating for the family.

New funds

In all of the above cases, if the fund is new or has only recently been launched, the performance (and risk shape) measures are replaced by subjective ratings covering the fund manager’s business, team, investment philosophy and process plus their research capability.

Analysing passive funds

With passive funds, we split by asset class and whether they are an ETF or a unit trust/OEIC. Within each of these sub-universes, the funds are ranked and scored on the following:

• Ability to track – we use ‘r-squared’, which measures the correlation between the returns of the fund and its respective index
• OCF
• Number of distribution partners – unit trusts and OEICs only
• Fund and group assets under management
• Return on any stock lending for funds which hold physical securities
• Counterparty risk for funds which engage in synthetic replication
• UCITS compliance and domicile

R-squared receives extra weighting so that the fund’s ability to track counts for half of its overall Diamond Rating.

All this makes for an independent, robust and trusted assessment of the quality of funds and fund families.