Isn't it true that modern society loves a ‘star rating’?

Most of us know what to expect if we book a 5-star hotel stay for a business trip when compared to a 3-star bed-and-breakfast for a weekend away.

The investment field is no different, with many institutions offering their own spin on star ratings and how to calculate them.

However, unlike the hotel industry, I would suggest many of the rating systems that assess the funds used by investors are best ignored.

Let's investigate why this might be the case…

A quick Google of a fund name will most likely return links to some of the major data providers out there such as Trustnet, Morningstar, and The Financial Times. For instance, I recently came across a UK Equity Fund that is currently rated as 5 Crowns on Trustnet through a system calculated by Financial Express - I won't however mention the fund as I wouldn't want anyone to consider this as a recommendation!

On these pages one might find star ratings, or similar, implying the relative quality of a product.

But, the challenge with these types of ratings is that the focus is solely on recent, short-term performance as opposed to long-term, sensible structure.

Without getting too granular, the Crown Ratings are derived using 3-year performance and volatility - in other words, how much the performance moves up and down compared to a benchmark, such as the FTSE 100 Index aka the Footsie 100 Index.

The thing is, 3-years is not nearly enough time, nor the sole use of performance figures insightful enough, to properly test the efficacy of a fund’s strategy or test the ability of the fund manager to pick shares or time markets.

In any case, remeber that picking shares and timing the markets is not a game played by sensible, systematic investors!

Reviewing a track record of 20-years would be statistically more prudent, however, to have benefited as an investor one would have had to identify the investment in advance which is nigh-impossible.

As Frederick the Great once said, "A crown is merely a hat that lets the rain in"!

At Wells Gibson, we believe strongly that structuring portfolios based on ratings that are derived with hindsight goggles is a dangerous game.

However, sadly, there are many investors out there that do pay attention to these ratings and are engaged in a repetitive cycle of buying-high and selling-low.

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