The Hindu Business Line : Rating of MFs enhances efficiency in the market

THE growing importance of mutual funds in India is evident from the fact that total assets under management as on March 31, 2004 stood at around Rs 1,40,000 crore, a growth of nearly 28 per cent over the FY2003 figure. While retail participation has been increasing over the years - and there is considerable scope for further increase, corporate investors still account for around 57 per cent of the AUMs.

It is in complementing the decision-making process of retail investors, besides the more organised institutional ones, that the role of independent rating is relevant and even critical. Moreover, apart from assisting investors choose high credit quality MF schemes, independent ratings also serve to bring to the forefront well managed and governed fund houses, thus promoting excellence in the industry.

While assessment of MFs usually takes the form of performance rankings, based largely on the measurement of risk and return, more sophisticated variants of MF evaluation include credit risk rating (CRR) for debt funds and grading of management quality of fund houses.

While CRR covers only debt funds, management quality gradings (MQG) rate the asset management companies, encompassing all schemes of the same.

The CRR of a debt fund is a symbolic indicator of the relative credit quality of the fund's investment portfolio. Specifically, the ratings address the relative expected loss a fund can suffer because of the default risk. The focus of credit risk assessment is on the downside risk. To measure the expected loss (or downside), raters use their own estimates of the default risk associated with each rating category. The raters make their assessment of the implicit rating of the fund's investments that are not rated.

While the credit quality of the securities that the fund is invested in is the focus of the credit risk calibration, a complete evaluation requires the measurement of the likely impact of various qualitative factors associated with the scheme being examined. Such qualitative parameters could include published investment objective; fund's investment guidelines/policies and style; quality of fund's management; its systems and controls; internal appraisal systems; portfolio composition and its diversification; fund's disclosure standards and accounting quality.

In this context, the portfolio composition of a scheme is of paramount significance. The understanding of the outlook for each sector the fund has invested in is critical. Typically, a fund invests in many sectors and each sector has its own dynamics and complexities. Further, they could all be in different stages of the business cycle.

Understanding the sectoral sensitivities is very important for an analyst to understand the industry's prospects. Sectoral sensitivities, in turn affect the performance of the companies operating in these sectors and consequently their ability to service the debt. Hence, an analyst would need to make a judgment on whether the extent of portfolio diversification is adequate, keeping in mind the future business scenario.

A MQG is a symbolic indicator of the overall assessment of the managerial and governance quality of a fund house. Such assessment is based on the evaluation of the relative abilities of the investment managers' decision-making systems; risk management systems and procedures; financial strength; and the level of transparency in operations.

An MQG reflects the grader's assessment of the management quality of the AMC with respect to the codes, rules, and guidelines established. The main factors evaluated to arrive at an MQG include organisation & management quality; governance quality; investment management procedures; risk management systems and policies; investor servicing performance; transparency in operations and level of disclosure; and performance track record.

On the issue of risk, identifying and monitoring it is a complex task. Counterparty, interest rate, liquidity, regulatory, compliance, technology, legal and operational risks are some of them that have to be factored in during the whole exercise.

MF ratings are designed to provide investors, intermediaries and fund sponsors/AMCs with an independent opinion on the performance and risks associated with various MF schemes.

Importantly, the value addition stems from the analytical rigour and independence of a specialist agency that provides such ratings. At the same time, attendant benefits flow to the funds in the form of enhanced marketing ability and differentiation of various schemes from others. Significantly, a robust evaluation exercise provides for an effective benchmarking of performance for fund management, irrespective of whether the fund chooses to use it's rating publicly or not.

The author is Managing Director, ICRA Ltd,

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