The recent crisis has deeply damaged investors' confidence in the asset management industry. It has re-emphasized that, even though asset managers sometimes call investors their 'clients', asset management is not about selling goods but about receiving delegation or mandate. The central question is therefore a question of trust. More specifically, investors face two fundamental questions. First, 'will the asset manager act in my best interest?' This question is at the heart of any fiduciary relationship and falls under the so-called 'moral hazard' category. It is mostly addressed by the imperative rule of avoiding conflicts of interests and by the design of suited contracts to align each party interest. Second, 'is the asset manager capable and skilled to receive such mandate?' This question falls under the 'adverse selection' category and covers the possibility for investors to assess the capability of a given asset manager.

As a matter of fact, evaluating asset manager capabilities is anything but straightforward. In the specific case of the mutual funds industry, the universe of possible candidates for delegation is so large that the 'capability' question cannot be addressed thoroughly for each single fund manager. Rating agencies help overcoming this difficulty by providing ratings on large mutual fund universes. Mutual funds are rated depending on their past risk-adjusted performance among a specific peer group. Those ratings are designed to help investors focus on a limited number of well-rated funds, i.e. those funds which have a successful track record.

This approach looks very reasonable but there remains a major puzzle: it is hardly consistent with the 'efficient market hypothesis' and the wealth of related empirical tests. Those studies, among which the preeminent one by Carhart in 1997, suggest that past risk-adjusted fund returns cannot help in predicting future risk-adjusted performance. As a consequence, two issues arise: Can some asset manager consistently deliver alpha over time? In case such an asset manager exists, how can investors identify it? These questions have become so difficult that some investors have abandoned their attempts at selecting an active asset manager. Instead they move on to passive investments. The crisis has added to the uncertainty, leading most major consulting firms to forecast that traditional actively managed funds will continue to be squeezed by passively managed products.

In this environment, the point of this paper is to contribute to the debate on how to identify capable asset managers. This is done by proposing a methodology to study the behavior and dynamics of fund ratings. Equipped with this method, answers can be given to questions such as: What is the probability that a five star fund remains five star one year ahead? How many times per annum does the rating of a fund change? Are fund ratings comparable with credit ratings? Do fund ratings have predictive power, etc? We hope that you will find the results in this paper interesting as well as useful in practice.

Nicolas Gaussel
Publishing Director
PhD, Global Head of Quantitative Asset Management