CHICAGO - Ibbotson Associates, a well-respected investment consulting and research firm, soon may begin offering mutual fund risk ratings, giving investors a quick gauge of a fund's total investment risk.
The risk rating would not be based on a fund's historical volatility, but on a review of the fund's investment practices, risk management and controls. Ibbotson likens the process to what credit ratings agencies do for fixed-income securities.
Ibbotson would not be the first to rate mutual funds for riskiness. Standard & Poor's Corp., New York, already rates about 350 U.S.-based fixed-income and money market funds for risk, and offers a portfolio monitoring service to mutual fund trustees.
But Ibbotson executives initially would focus on equity funds, where they say most of the interest is.
The process would involve an evaluation of a mutual fund in three ways. Publicly available documents, services such as Morningstar Inc.'s fund performance ratings and returns-based style analysis could be used initially to analyze a fund, said Scott Lummer, managing director with Ibbotson.
Fund cooperation needed
To do more, Ibbotson executives would need the cooperation of the company. Ibbotson would quantitatively analyze portfolios using more up-to-date securities holdings, and possibly do times series analysis of a fund's investments.
Also, Ibbotson would meet with the fund company about investment philosophy, its use of derivatives, risk management processes and, perhaps, get explanations as to why a fund might be deviating from its intended style, or performing outside of expectations.
Initially, to get the service going, Ibbotson is likely to foot the bill for the rating system. If it gains acceptance, the fund companies themselves would pay to be rated, Mr. Lummer said.
An unscientific sample of fund companies indicated they would cooperate with Ibbotson, he said.
Ibbotson executives are considering assigning funds firecracker symbols, on a scale of one to eight, Mr. Lummer said.
Investors may welcome ratings
With available information on mutual fund riskiness limited, the ratings could be welcomed by investors in mutual funds.
Mutual fund companies aren't doing a good job of fundamental risk management, Mr. Lummer said.
"Most mutual fund companies have very little idea what individual managers are doing," he said.
And for those considering investment in a mutual fund, it's "almost impossible" to tell what risks they're taking, he said.
Not everyone agrees risk management at mutual funds is any different from risk management at individual money managers.
Jeff Molitor, principal and director of portfolio review for The Vanguard Group, Malvern, Pa., said: "We probably do it (risk management) more than most separate account managers," he said.
Speaking of mutual fund rating systems in general - he declined to comment on Ibbotson's - he said it is a problem when ratings focus on past returns or volatility. A good rating system would also include qualitative analysis, Mr. Molitor said.
Peter Anderson, chairman and chief investment officer for IDS Advisory Group, as well as executive vice president for American Express Financial Advisory, Minneapolis, also said mutual funds are no riskier than separate accounts.
"My hunch is that large mutual fund companies" have sophisticated risk management operations. Where there might be looser controls is among smaller and midsized managers, whether they work for mutual fund companies or independent investment management shops, he said.
IDS chief likes idea
He think's Ibbotson's ratings are a good idea.
"It's a subject that is near and dear to the hearts of our board," he said. His firm's board just completed a full review of its risk controls. While particular attention was paid to derivatives, the review covered all aspects of risk, Mr. Anderson said.
Edward D'Alelio, chief investment officer and head of the risk management committee at Putnam Investments, Boston, acknowledged risk management and controls among mutual fund companies might be uneven.
He said a rating system for mutual fund risk might be a good idea, given the industry's push for performance.
"The market's focused on reward, and not risk," he said. The trick is to make sure managers are taking proper amounts of risk, so performance is good, but within the appropriate guidelines for a particular fund, he said.
Mr. Lummer said some investors still will want to perform their own due diligence, and wouldn't rely on a rating system. But others are looking for more information.
He said risk measures now available, such as standard deviation of returns, are based on historical data and are poor predictors.
Timing might be good
The timing for a mutual fund risk rating system might be good, with both investors and the Securities and Exchange Commission looking for ways to improve the management of risk at mutual funds. The SEC last year began an effort, with private industry input, to rate mutual funds for riskiness, but has run into some problems as to the best approach.
S&P, meanwhile, is exploring the possibility of adding equity mutual funds, but that process is "very preliminary," said Sanford Bragg, managing director in its New York office.
Ron Peyton, president and chief executive of pension consultant Callan Associates Inc., San Francisco, said the mutual fund industry could improve its risk management oversight, particularly given the strong returns experienced in mutual funds.
"We've had very good times....That makes people lax," he said.
And Mr. Peyton said he doesn't expect a lot of activity from mutual funds in that area until there is some type of blowup that affects mutual funds directly.
"It's fair to say mutual funds probably are doing less than institutional money managers are" with risk management and controls, said Richard Klotz, partner in charge of Coopers & Lybrand Consulting's financial risk management practice, New York.
But he said larger mutual funds and money managers are headed in the right direction. As they make progress, the rest of the industry will follow.
Putnam a leader
Putnam's Mr. D'Alelio said he thinks his firm has been a leader in dealing with the risk management issue. Putnam hired a full-time risk manager about six months ago; its risk management committee was established about two years ago. He said the push toward improved risk management is likely to continue across all types of money managers.
"Increasingly (risk management) is the real issue for the 90s," he said.
Tanya Styblo Beder, principal with risk management consultant Capital Market Risk Advisors, New York, agrees mutual funds must walk a tightrope, because performance is so important to their business.
She also said mutual funds are faced with daily valuation, raising the importance of pricing models.
But, she disagrees that mutual fund companies lag other investment managers in managing risk and putting controls in place.
Meanwhile, Ibbotson will go ahead with its rating system.
"Initial results are promising," Mr. Lummer said.
Ibbotson now has two people devoted to the effort. Performance will not be a part of the rating, Mr. Lummer said. Ibbotson will leave that to firms like Morningstar, Chicago, which offers performance ratings and evaluations of individual mutual funds.
He said Ibbotson will make a decision on whether to take the project outside and market it to mutual funds in a few months.
