:: Global Credit Ratings :: Asset Management and Fund Ratings

GCR's Asset Manager "Management Quality" Ratings (mq ratings) assess an asset manager's organisational structures, risk management capabilities, management characteristics, operational practices and controls, in order to arrive at the organisation's overall quality. The ratings are intended to help the investor assess the skills sets of the wide range of portfolio managers, and facilitate the process of evaluating investment management firms' overall quality, regardless of size, ownership structure, and scope of operations. This assessment is expressed through a rating, which is assigned on a scale as follows:

Management Quality Rating Definitions

AAA(mq)	Entities rated AAA(mq) are judged to exhibit an excellent management and control environment, which meets or exceeds best international practice and benchmarks.
AA(mq)	Entities rated AA(mq) are judged to exhibit a very good management and control environment.
A(mq)	Entities rated A(mq) are judged to exhibit a good management and control environment.
BBB(mq)	Entities rated BBB(mq) are judged to exhibit an adequate management and control environment.
BB(mq)	Entities rated BB(mq) are judged to exhibit a poor management and control environment.

GCR’s Fund Ratings are an independent assessment of a specific fund’s exposure to factors that could lead to unexpected Net Asset Value and total return volatility. This assessment begins with an analysis of the fund’s historical performance in terms of price and total return volatility, and then focuses on the fund’s portfolio quality and market risk exposure. This assessment is made within the context of a fund’s published investment objectives and policies. GCR’s Fund Ratings indicate an opinion regarding the fund’s ability to preserve principal value under varying market conditions that may be affected by credit, interest rates, liquidity, as well as other market conditions. This assessment is expressed through a rating, which is assigned on a scale as follows:

Note a “+” or “-” may be appended to a rating to denote relative status within the AA, A & BBB rating categories, in respect of both Management Quality and Fund ratings.

It is important to note that GCR’s Management Quality Ratings differ fundamentally from its traditional credit ratings, which refer to an issuer’s ability to meet its debt obligations. Furthermore, Management Quality Ratings are not meant to be used for determining future performance of a fund, portfolio or other investment vehicle, or as an indicator of future volatility. An overview of GCR’s approach to rating individual funds is reflected below.

Although GCR’s analysis of an asset manager’s quality takes into account quantitative factors, such as the historical performance of funds under management and the financial strength of its balance sheet and P/L, the ratings emphasise qualitative analytical factors over quantitative factors. As such, the rating process focuses on the following 4 principal analytical areas:

GCR begins its review of the asset manager’s business characteristics by first focusing in on the firm’s organisational structure. Analysis of a firm’s organizational structure is based upon identifying and assessing the quality of the reporting structure, and the efficiency of the various functions and responsibilities within the organization. It also is a study of the relationships that exist within the firm, with its service providers, clients and with any affiliated entities including parent companies and or shareholders. This analysis is a critical component in the overall process of assigning asset management quality ratings.

Beginning with an assessment of whether the size and structure of the organization provides for an efficient use of resources, GCR looks to identify if there are clear lines between departments, and that the reporting structure provides enough independence to allow problems to be readily identified and reported without burdensome structural mechanisms that might serve only to suppress effective risk management. Compliance control is always a fundamental issue within any fund manager’s organizational structure. Dual control systems, which facilitate redundancy in oversight, can enhance the rating.

The question of whether the asset manager operates as a separate business unit within the corporate structure is addressed. Whether it is a standalone subsidiary, affiliated company, or a joint venture, it is important to determine if the relationship with its parent or shareholders enhances or places undue pressure on the manager’s operations. The fact that the firm or its parent is publicly listed itself, can have a bearing on such things as the amount of publicly available information, its ability to raise additional capital for planned or unforeseen demands and its exposure to certain event risks. The possibility of event risk, such as a merger or a take-over, may increase, for instance. A recent or upcoming change in corporate ownership can have a major impact on an asset manager’s investment philosophy, cultural approach and overall operating environment. The relationship between the parent company and the affiliated company can also have a direct impact on the outcome of the rating. A strong parent operating under a vigilant and clear regulatory environment, with a strong financial profile, and demonstrating a willingness to support its affiliates can enhance an asset manager’s rating. On the other hand, a weak parent represents a risk as it may look upon its affiliates as a potential funding resource, thereby impacting negatively the same rating. Another aspect of the relationship which GCR reviews is the extent to which there are proper and institutionalised “Chinese walls” between the affiliated companies and also how stringently these fiduciary responsibilities are maintained and promoted between the respective entities.

An analysis of the business environment includes identifying the asset manager’s client base. Funds geared toward the retail market require a very different operational structure and approach than one targeting institutional investors. The nature of its client base brings different risks that must be addressed adequately. For example, an asset manager with large exposures to an institutional client base is prone to large movements, both inflows and out, and as such the firm should have specific structures and operational procedures in place to handle them efficiently. The extent of relationships with clients is also another important consideration. A retail operation may rely heavily on its relationships with intermediaries or directly with investors. GCR tries to gauge to what extent those relationships are vital to the firm’s operations. Relationships can also be heavily dependent on key personnel. This aspect is further detailed in our analysis of the management team in particular, but here we focus on management’s efforts to protect key relationships from risk of personnel turnover and on its personnel policies in regards to retention, compensation and other human resource issues. Another facet of the business environment is an assessment of whether “brand” is a significant factor in its operations. GCR looks at how the firm markets its brand and what internal procedures are in place for monitoring its markets and its sales processes.

Another area of our analysis takes an in-depth review of management characteristics in regards to experience, track records, independence, style, approach and relationships within management teams. GCR begins with a review of management biographies and interviews with key senior managers in order to assess the level of experience and to measure qualifications. Although generally speaking, a long track record of success is a positive indicator, it is even more important if that prior experience matches and is relevant to the current strategy and style of the organisation. Interviews focus on determining the investment approach of the firm’s managers, his or her specific views on what constitutes the investment culture within the organisation. It is particularly important in those organisations that rely heavily on individual managers, to get a sense of the level of risk present in the event of personnel departures. For those organisations which operate more on a team approach, GCR discusses in detail the functions and responsibilities of each of the team members. A breakdown of responsibilities is done to determine if there exist non-core activities that could distract or divert resources from the efficient management of the firm. Many of these teams or key individuals may also manage a number of different funds. Each of the funds under management is assessed as well and any disparities in performance are analysed and questioned.

With the overall structure clearly identified, GCR’s analysis moves on to assessing the efficiency of the firm’s operations given the existing infrastructure systems and the mechanisms in place to respond to any inherent challenges. The quality of the asset manager’s information systems can have a direct impact on the efficiency of its operations. A review is conducted of the systems in place to communicate with the market, service providers and clients, providing the basis for measuring that efficiency. All of the asset manager’s activities in the areas of management reporting, trading, client servicing and administration, securities processing and custody are reviewed from an operations point of view.

A review of the historical performance of the various funds under the asset manager’s control is an important tool when used as part of overall analysis of the quality of the management. However, GCR does not assign mq ratings based on historical investment performance, but rather on a firm’s ability to achieve solid targeted results consistently across a range of market conditions.

An analysis is conducted of an asset manager’s investment and operational strategies in the context of its stated investment philosophy, policies and goals. Identifying the organization’s strategy and decision-making process is at the heart of this analysis. Questions are posed to understand the investment philosophy and to determine how investment objectives are established. The process undertaken for determining investment strategies is reviewed, including how the strategy is defined, quantified, and most importantly, how it is implemented. The decision-making process for allocating assets and for identifying what securities are eligible is reviewed. Also reviewed is how monitoring of that strategy is conducted and under what circumstances can that strategy be altered. Finally, GCR looks to determine to what level of consistency has the investment policy been applied.

The specifics of each the funds under management are also reviewed. A change in asset size in any fund, for instance, is flagged to determine if there has been any shift or drift in investment philosophy. Fund fundamentals, such as liquidity levels, rate of turnover and the ratio to expenses, are reviewed and analysed. A more detailed investigation of the client-base is undertaken with an eye toward identifying and explaining any changes in that investor base. Performance is once again highlighted, but in the context of market performance in general. Portfolio composition is reviewed and carefully compared to the stated investment objectives of each individual fund. Any changes in style calls for in depth questioning as to why such a shift has occurred. The specific practices utilised in the course of building a fund portfolio is also reviewed. This includes identifying any use of leverage or derivative products to enhance return. Questions regarding these practices are meant to determine the extent of their use, their place within the investment philosophy and strategy of the organisation. It is also important that we see in management a clear and thorough understanding of the risks inherent in their application.

Ancillary support structures are also reviewed in order to examine the capabilities and breadth of those resources. In-house research teams are analysed to determine the extent and quality of the information used in investment decisions. Equally important is an examination of how external resources such as research from brokers is incorporated into internal research activities. Additionally, access to company investment information is reviewed to see to what extent interaction exists between research teams and companies in the portfolio, in terms of visits and timely communication.

Assessing the firm’s ability to exercise proper control of its operations in order to effectively identify and address the various forms of risk it faces is a fundamental part of GCR’s analysis. Risk management and compliance with regulatory requirements are a key concern and focus within GCR’s assessment of management. In the area of regulatory environment, GCR undertakes a comprehensive analysis of the laws and regulations impacting the asset manager’s operations. This is done for every market where GCR issues mq ratings. Through direct contact with the relevant regulatory bodies and constant monitoring of new developments, GCR keeps abreast of key issues in regulatory oversight.

A review of the firm’s regulatory compliance is an important part of assessing a firm’s capability to manage risk. GCR undertakes a comprehensive review of the firm’s compliance structure in order to assess its capacity, as well as its compliance philosophy. This includes a review of its written internal procedures and guidelines, reporting systems, its track record with regulators and its compliance with licensing, capital and general reporting requirements. Any history of problems in this area is carefully reviewed for cause and correction. Management’s process for reviewing compliance issues and for updating its procedures are also investigated.

GCR analysts question individual managers on their own specific risk management procedures, including what oversight responsibilities and practices are employed over daily trading and investment decisions. It is important to determine who within the organization is responsible for managing risk related activities and to what extent he or she has the appropriate levels of authority to deal effectively with that risk and to enforce the firm’s risk management policies. GCR reviews the quality of the internal and external audit system and looks specifically at past compliance lapses to evaluate how they were addressed and eventually corrected.

Financial staying power is a key element in the successful operation of an asset management organisation. GCR is particularly concerned with an asset management firm's ability to fund current and future operations and meet capital requirements through internal cash generation, and to be able to do so while supporting current and future business activities. GCR reviews the relative importance, financially, of each fund to the firm’s overall business in terms of revenues and profits. This review is further analysed later in the context of questions to management regarding strategic direction within the firm’s overall operating philosophy. GCR’s assessment of financial fundamentals considers not only the current financial status of the company but also trends in earnings, cash flow, profitability, and capital adequacy.

Although size is a consideration when evaluating financial strength, as it can have a direct bearing on the firm’s ability to withstand downturns in economic activity, it is not in itself a defining factor for the rating. Size, however, can be a contributing factor in the firm’s operational efficiency and is further analysed in that context. Comparative analysis to other asset managers is undertaken, wherever possible, and is based on an appropriate sampling of peer groups. Financial strength also impacts the firm’s ability to retain important staff through appropriate financial incentives thereby maintaining competitiveness and retaining clients, particularly in the institutional market.

While thorough quantitative analysis is important, the qualitative characteristics of our analysis cannot be overemphasised. It is critically important to look “beyond the numbers” to evaluate the intangible strengths and weaknesses of any asset manager. The analytical process described above has the clear goal of assessing the overall quality of the asset manager in question. That assessment comes from evaluating the organization’s historical performance, financial strength, structure and environment, management characteristics, strategies and operations. In the end, the rating assigned is based upon a comparative analysis of all these factors within a universe of other comparable asset managers in the market. With the above as a starting point, GCR is also in a position to undertake an independent assessment of a specific fund’s exposure to factors that could lead to unexpected Net Asset Value and total return volatility. This adds considerable value to prospective investors in a specific fund or portfolio as highlighted in GCR’s Fund Rating Criteria.

Although fundamental analysis of fund performance is an important starting point in our assessment, it is important to stress that GCR does not subscribe to a ‘box' approach. This implies that we do not simply infer a rating based primarily on quantitative analysis or any rigid “checklist” of factors. Rather, the approach is to integrate our quantitative analysis with a robust and thorough qualitative analysis, relying mainly on the latter to arrive at the appropriate rating. GCR's analytical process for its Fund Ratings focuses on the following 3 principal analytical areas:

GCR’s assessment of a fund’s management focuses on whether that management is effective in maintaining an investment policy that is consistent with the fund’s stated objectives and with the expectations of its investors. A detailed description of the key factors that contribute to an assessment of fund management quality is reflected in the previous section.

The principal areas of analysis in assessing the historical performance of a fund centre around 1) a quantifiable analysis of total returns over specified periods of time, generally a three and five year horizon, in comparison with a benchmark of low risk fixed-income instruments, usually government securities, and other indices; and, 2) analysing how historical volatility relates to the fund’s investment objectives, portfolio selection parameters and existing market conditions over the relevant period. The latter analysis is undertaken within the context of the portfolio quality and market risk assessment discussed later in this methodology review.

GCR’s quantitative analysis of a portfolio’s historical performance uses traditional analytical tools and measures that summarise various aspects of fund performance over time. The basic ingredient in the measures is the calculation of monthly return, including average and excess over appropriate benchmarks. In addition, these measures are based both on calculating total returns with and without considering any load or expense charges. However, GCR believes that a more accurate analysis of a fund’s performance and total return include calculations that take into account fund expenses and turnover.

One of the principal goals in the analysis of current portfolio quality or risk is to determine to what extent it compares historically with the investment policies and its related historical risk profile. By reviewing the potential for short term volatility in the form of possible principal loss relative to that historical performance, current market conditions or its stated investment objectives, GCR is able to give that fund an ordinal ranking within a spectrum of volatility. The factors that contribute to that volatility include risks in the form of interest rate movement, credit default, liquidity levels, portfolio concentrations, payment modification, speculative derivative use and foreign currency exposure. GCR looks at each of these factors when reviewing the profile of the fund portfolio and considers the effects of these risks when evaluating the overall price sensitivity of a fund. At the end, it is the total portfolio risk that is measured, after taking into account the fund’s efforts to mitigate the individual risks through diversification or other risk aversion techniques. A brief description of each of these risks follows, along with GCR’s views as to their potential impact on a fund’s rating.

Interest Rate Risk. Interest rate risk, expressed as a portfolio’s sensitivity to interest rate movements, is a key determinant in a fund’s potential volatility. As a security’s (or portfolio’s average) maturity is extended, more uncertainty is introduced as to the direction and size of possible future movements in interest rates. Therefore additional risk is present, although this can be mitigated through various hedging techniques. The sensitivity of a security’s market price to that risk is what is important. That sensitivity is generally measured by means of the security’s duration and its convexity.

Credit Risk. In its basic form, credit risk refers to the possibility that an issuer of a security will be unable or unwilling to meet its obligations to pay interest and principal on time and in full. GCR undertakes an analysis of the securities to determine the overall aggregate credit risk inherent in the portfolio. It begins by reviewing any available credit ratings already issued by GCR on the securities in question.

It will also utilise ratings not issued by GCR if from a GCR recognised rating agency. In the case of unrated securities, GCR will attempt to assign preliminary (unpublished) ratings based on available information, but may “haircut” credit risk assessment of the portfolio by an appropriate factor to reflect higher credit risk. The presence of high credit risk impacts the spread risk or yield at which these securities are traded. That spread risk by definition results in higher price volatility. Higher credit risk can also result in higher total returns and therefore, depending on the fund’s investment objectives, can fall within acceptable ranges. Finally, the overall credit risk assessment takes into account the size and diversification characteristics of the portfolio.

Liquidity Risk. The degree of liquidity in a security is often reflected, as in credit risk, in its yield spread. How quickly that security can be sold and at what price is often a function of its liquidity, with low liquidity securities suffering price discounts over and above comparable securities of similar maturity. An over exposure to illiquid assets places larger risk on a portfolio.

So it is not surprising that diversification within a fund’s portfolio itself is considered a risk-reducing trait. The guiding principle for creating a dispersed portfolio is that each investment carries inherent risks, which are affected by given factors differently. These differences once combined should cancel each other thereby removing the total risk. Any concentration in any particular area, such as security type, industry or currency brings on additional risk, which ultimately could translate into volatile movements in price and value. The extent to which diversification is present is looked at also within the context of the fund’s stated investment objectives.

Pre-Payment and Extension Risk. There are particular types of securities that carry additional risk in the form of prepayment or extension risk. This is an applicable issue in those funds with fixed-income securities in their portfolio. Mortgage-related securities are particularly prone to this type of risk as they exhibit high sensitivity to interest rate movements. An analysis of the portfolio’s holdings is undertaken to identify securities held which exhibit this type of risk exposure, and reviewed to see if the amount of risk is significant or whether strategies are being employed to offset the risk through diversification, as described above, or through other hedging techniques.

Derivatives Risk. The use of derivative products by investment funds has increased in recent times as new products are developed and marketed. Their use as hedging mechanisms are important tools for reducing risk within a portfolio and are positive influences on a portfolio’s risk profile. However, the use of derivatives for speculative purposes introduces additional risk, particularly if the practice is not adequately monitored or understood by the fund’s management.

Currency Risk. Currency risk appears when a fund holds deposits or securities within its portfolio denominated in a currency different than its own base currency. This deviation exposes these holdings to foreign exchange rate movements resulting in potential fluctuations in value and return. The amount of exposure and related risk is reviewed by GCR. The fund’s historical volatility attributable to currency movements is identified while current exposure is assessed for its potential impact on current holdings. As mentioned in the case of derivatives, there are specific hedging techniques that can help reduce the risk in this area. The application of currency hedges is reviewed to determine their efficacy.