S&P Fund Services annual review of the sector

Fund upgrades in the American equity fund sector recognised the quality of fund management at JP Morgan securing the company an impressive four upgrades, while performance in a hostile environment to growth led to downgrades for fund managers who pursued an aggressive growth style, says S&P Fund Services in its annual review of the sector.

The review covers 98 funds, with 28 achieving an A rating, 58 AA rated and six attaining an AAA rating. Six funds are Not Rated. Overall, 14 funds received upgrades while 16 were downgraded.

Significant among the upgrades was JP Morgan, who received four fund upgrades. JP Morgan’s quantitative process was recognised as a key factor behind the success of the US and US Dynamic funds, both moving up a step to AA from A. “The quantitatively driven process has been very successful in other markets and the behavioural finance team, now headed by Silvio Tarca, has done a good job rolling it out in the US,” said Stephen Adams, the lead American equity fund analyst at Standard & Poor’s.

Two other JP Morgan funds – American Micro Cap and US Value – were upgraded based on the quality of management and experience of the management teams. “Christopher Jones, who manages the Micro Cap fund, has been hovering on the verge of an upgrade for quite a while, and the fund’s long-term record and good team fully justify the increase to AA from A,” said Adams. “Jonathon Simon's experience and consistent approach on the US Value fund strongly supported the upgrade to AA from A.”

Other managers seeing upgrades included Schroders, Franklin Templeton, Fidelity, Union Investments, Janus, Martin Currie and Gartmore.

As well as an upgrade, Gartmore saw two funds down-graded following poor performance. The Gartmore Investment Funds Series 1 - US Opportunities Fund and its Luxembourg-based Sicav version, which is separately rated, dropped one step to A from AA. “Gil Knight's willingness to take very large bets has not been rewarded,” said Adams. “Year-to-date performance has been dragged down by the large overweight to technology and poor stock selection. Performance may swing back, but Knight's apparent loss of confidence in his stockpicks and the lack of structure in the process lead us to downgrade this fund.”

Knight suffered for his growth orientation during a year that was particularly harsh on growth strategies. “At the last review we noted the presence of a large number of rated growth funds among the top performing funds, and we noted some optimism among growth managers that the long period of underperformance of their style was coming to an end,” said Adams. “Sadly, the optimists had a rude awakening in the second half of our review period after what can only be described as truly dismal returns. Style has been a clear differentiator this year - the ‘growthier’ the style, the worse the results, whatever the capitalisation.”

Another manager who suffered for an over reliance on growth was Alan Blake of the Legg Mason US Large Cap Growth fund, which dropped to Not Rated from AA. “Relative returns have been dismal in 2006 because of the emphasis on higher growth names. Following poor returns in 2004 and 2005, the fund is 5% shy of its Russell 1000 Growth benchmark and more than 8% adrift of the peer group median this year, and cumulative returns are now bottom quartile over both three and five years. While we have considerable respect for the manager and look forward to an improvement in performance, we had no choice but to remove its rating.”

The Legg Mason Growth & Value fund was also downgraded, to A from AA. “Following strong outperformance in 2003, the fund has produced disappointing returns, modestly, yet consistently, lagging the peer group. Cumulative returns now rank in the third quartile over three years.”

Other fund managers experiencing downgrades included JPMorgan and UBP.

After another tough year, many managers are cautious and positioning themselves more defensively, anticipating a period of relatively weaker earnings reports after the strength of the last few years. The decline in the oil price has supported the market, and the view that interest rates have peaked has generally been supportive of equities. Combined with the strength of corporate America's balance sheet and cashflow, the market has been resilient, if not buoyant of late. The shift to more defensive positioning has also probably contributed to the strength of the Dow.

After so many false dawns, it looks as if many of the trends that we have witnessed in recent years, such as the outperformance of smaller companies and lower quality stocks, and the dominance of value funds over growth, have drawn, or are drawing to, a close.

The review period covers 12 months from 1st September 2005.