The key characteristics Zenith looks for when rating funds

Whether in life or in finance, we all hate nasty surprises. It is why we take out insurance, do our due diligence, and consult with experts before making any major decisions.

In the funds management industry, part of the due diligence process for funds is becoming rated. That is, being put through the paces of a ratings agency in order to qualify for a host of benefits, such as being made available on platforms and added to approved product lists.

Make no mistake, this can be a big deal. Research houses have great power as they can determine whether or not a fund gains access to the huge swathes of capital controlled by financial planners and advisers. A rating is a fund's "ticket to play".

If a fund is rated highly, the more likely it is to receive flows of capital and, if it is included in a model portfolio, millions of dollars could be directed its way each year. It is a significant responsibility not lost on Zenith Investments Partners CEO, David Wright, who describes the position that his firm occupies as “a fairly unique position in the financial services industry and quite a fortunate and privileged one”.

So, what makes for a great fund? As part of Livewire’s inaugural Undiscovered Funds Series, that’s what we’re here to find out. Wright talks of "staying true to label" and “delivering upon the investment objective” as key elements of successful funds, along with a host of other quantitative and qualitative factors.

In the interview, Wright also talks about:

• Zenith’s role in unearthing hidden gems, 
• the changing landscape of funds management, and 
• why it is important that an individual is ultimately responsible for a fund’s performance.

You can watch the full interview by clicking on the video player or scroll down the page to read a summary. 

Topics discussed

0:00 - Introduction
0:23 - A little about David's background
1:30 – Zenith’s role in the financial services industry
2:47 - What is the process for a fund to be rated?
4:50 - Does what it says on the tin
6:20 - Art versus science
8:07 – Question time
9:46 - Three-year track record - do you ever rate funds earlier?
11:34 - Once a fund is rated, what benefit does it provide?
12:56 - Do you ever get it wrong?
14:05 - Major changes in the funds management landscape
16:07 - Where should I start a new fund?
18:09 - True or false with David Wright

A little about David's background

"I've always worked in research and investment research businesses. Back in 2002 was when we established the business. We saw an opportunity to provide a more concentrated research service to advisors. 

And the thing that was bubbling up at the time there, if you think back to that period, it was just post the tech media telecom boom and there was a lot of need for advice around portfolio construction management, monitoring and reporting. 

And so to be honest, that's still core to the business today, but that was really the rationale.

There were research services but not too concentrated on those two areas in greater detail. We saw the opportunity and established the business from there.

The role of Zenith in the financial services industry 

"I feel we, with others and only a small number of others, have a fairly unique position in the financial services industry and quite a fortunate and privileged one. 

Our clients are financial advisers, so we are providing them with investment research and recommendations on managed investments. 

That includes both unlisted and listed. Increasingly listed - it's been a big growth space - through ETFs and exchange-traded managed funds in recent years, and portfolio construction management, monitoring reporting services to advisors. 

What is the process for a fund to be rated?

There are thousands and thousands of funds. 

The first thing you need to do really is try and filter out those that we don't regard as being the highest quality and those that are really going to deliver upon the investment objective and provide competitive returns at an acceptable level of risk to the end investor. 

So although our clients are the financial advisors, we are always thinking of the safety of the end investor in terms of investing in the funds.

It is a detailed process and I won't bore the audience with all of that detail, but certainly, you want to be investing with managers that are stable, have an established footprint, strong corporate, the ability to support their fund or funds in the marketplace in terms of both the sales marketing and distribution function, and the ability to raise funds. 

And the investment professional's experience, they've seen different market conditions and managed money through different market conditions and have a commitment and are very clear about what their competitive advantage is in managing the portfolio or asset class in which they're managing. 

And then, of course, there's the risk, which is very important. 

We don't ever want to be associated with managers or funds that blow up and have or investors experience permanent loss of capital. 

So, that's the risk of the investment's key criteria that we look at.

Does what it says on the tin?

There is what we call in the industry "true to label". 

What you're wanting the manager to do is what they say they do. You don't want nasty surprises, particularly on the downside, but even on the upside. 

Sometimes you look at the performance of a fund and you think, "Well...This is a growth manager that has performed super well in a value-oriented market, that doesn't seem right".

When you drill through to that, that might have come about through style drift, the manager has kind of moved away from their core competitive advantage. 

And that's a concern, you don't want that, especially when you're building a portfolio of complementary investment styles. 

The ability to deliver upon the investment objective that they have is absolutely crucial, no nasty surprises.

Art versus science

I think some part of [fund rating] definitely is art. 

We like to think of our process as being quite quantitative or the science aspect at the front end. Everybody in the industry has access to manager performance, they're able to slice and dice performance and risk and ratios in every which way. It's really an interpretation of those ratios. 

What we're trying to do, when I say at the front end, is really identify those managers and funds that we think are worthy of our research time and analysis and have the potential to be well rated and used in client portfolios and deliver upon that investment objective that we spoke to before.

However, the backend is really going in, reviewing the managers and investment personnel on an in-person basis. We find that very important in being in the manager's own habitat. And not just seeing the PM but also the investment analysts or other investment professionals within the team and ensuring that they're all singing from the same hymn book, so to speak. 

You can also observe the different personalities and you generally don't want groupthink, you want people with different backgrounds. 

There's a lot that can be gained on the art side by meeting people on an in-person basis and running through a detailed due diligence questionnaire.

What sort of questions do you ask in the review process?

It varies widely. We certainly try to work through the review process in a logical fashion. Start with organisation and team, talk about the breakdown of responsibilities, even in large organisations. 

We do like to see someone ultimately responsible for the performance and the returns that Australian investors are investing in, even if that's a global firm. 

Often with larger global firms, they'll have portfolio management teams, we much prefer to have someone who's on the hook for the performance of the fund and the delivery of that to investors.

We don't want a situation where a portfolio management team will say, "Well, that wasn't my responsibility, that part of the portfolio." 

You want someone ultimately responsible for the returns and performance that investors buy into. We don't want abdication of responsibility, that's the critical part of what we're looking for managers to deliver to investors.

Three-year track record - do you ever rate funds earlier?

Well, we absolutely do. And I think in some ways, the three-year period is a bit old-fashioned. 

For a long period of time that probably was the standard that managers and funds may not be reviewed and rated prior to a three-year sort of track record. 

Our clients and the end investors are really looking to us to unearth hidden gems. And so, often that is early and prior to the three years.

Having said that, it would never be the case that we would provide a rating on a manager and fund where we don't know the investment professionals, they're inexperienced, they don't have a track record managing in that way or that asset class, that would never happen. 

The criteria we're really looking for is that they are experienced investment professionals, they have run money in that fashion before, they are backed by a stronger corporate. 

In this day and age, it's pretty rare that you'll have a boutique established just with the capital of the founders and run and establish the business that way. It's much more common to have a partnership with an incubator or an institution or a distributor that provides, both working capital and seed capital for funds. 

Once a fund is rated, what benefit does it provide?

It certainly provides for investors, we think, some assurance or certainty that the manager has gone through a really rigorous process to arrive at the rating. 

That should provide some comfort to both investors and advisers, their clients being the investors. 

A rating for the fund is really almost, in the Australian market at least, a ticket to play, particularly within the intermediary or advisor network. 

The vast majority of advisors are not going to use funds or products that are not rated. And the major reason for that, is they don't want to take that risk on themselves of something going wrong. 

They want the comfort that it has gone through an intensive due diligence process. And to be honest, the legal compliance regime and professional indemnity insurance just often don't cover products that are not rated. 

It really is important for managers to have investment ratings, certainly in the Australian market, to be able to be used by advisors and investors.

Do you ever get it wrong?

I'd love to say we never get it wrong, but neither you nor your viewers are going to believe that. I do however feel that, whilst we don't get everything right, and there have been managers that start off at lowly rated and have done really well, I do feel very strongly that we've managed to avoid the big blowups. 

Products that have been heavily and actively marketed direct to investors, through aggressive advertising and so forth, and not gone through the research process, we have avoided those that have resulted in permanent loss of investors' money. 

And I think that's a really important function of investment research.

Major changes in the funds management landscape

It's been a really dynamic period and there are far more listed managed investments than there were five years ago. The whole ETF space has grown enormously in the Australian market. 

Initially, mostly passive exposures, but now we've seen exchange-traded managed funds, many of which are active. So that's certainly been a massive growth space in the last five years.

More recently we've seen the launch of dedicated ESG or environment and social governance type products and almost a sub-sector of that in the last year or two has been product with climate change and low carbon emission type objectives to them. 

We've seen the launch of private equity, private debt, and real asset funds. We see in the newspapers or what seems like almost on a daily basis, the future fund and the industry super funds having exposure to some of these asset classes. And so, investors have naturally said to their advisors, "How can I get exposure to those asset classes?" 

We are seeing more ability and availability in those less mainstream or private asset spaces than we did even five years ago. So yes, there's a lot happening and a lot has changed in that time.

Where should I start a new fund? 

It's a common question because everybody wants to know where's the next best thing. In such a competitive market that can be really difficult. 

For a long time, we said global small companies were an area of the investment landscape that wasn't well represented down here in Australia. We've had growth in that area. 

One of the areas at the moment that does seem to be underrepresented, and it is in Australian equities, is midcap or middle-size companies. 

We've got a lot of small companies, and we've even got a reasonable universe of microcap or managers that invest in very small listed businesses, but there's still only really a handful of managers and funds that invest specifically in that mid-cap space.

And one of the things you'll see in the Australian market, is that different market cap segments perform very differently, particularly over short periods of time. 

The mid-cap space behaves differently to large cap and small cap. There's some merit, definitely some merit from a portfolio perspective, in holding mid-cap or a dedicated mid-cap manager in a portfolio. So, that's an area that we think is probably underrepresented.