How Morningstar are spearheading financial industry transparency

Take the guesswork out of financial analysis

Nick Cheung 13.04.2017
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How do you reduce price volatility, understand true reach and increase trust in the investor market?

The answer is, encourage clear and honest financial reporting and industry integrity that puts the investor first.

Transparency is the extent to which investors have ready access to required financial information about a company - price levels, market depth or audited financial reports. If two companies have similar leverage, market capitalization, market risk exposure, earnings and return on capital, investors will put their money into one that runs their business with clarity in its financial reports, rather than complexity. 

Owning a mutual fund means investing in multiple companies, and at Morningstar, we believe investors should know what underlying investments comprise their securities. Transparency shows investors how much risk they are exposed to with a security, helping investors make more educated decisions on where to put their money.

What else makes for a sound financial advisor? Elements like developing a client’s financial discipline and aligning their priorities towards goal based investment and savings, and keeping advisory costs down all go towards achieving trust over the long term.

If you are interested in regularly monitoring how your securities are performing, this may be done by studying the history of the stock’s returns and market fluctuations to determine possible fund performance in the future. You may also compare their returns with the performance of related securities, benchmarks and other asset classes to make proper investing choices that better meet their goals.

The bottom line is, when an advisory puts investors first, you can control so much more of their experience through sound practices, even if you don’t know where the market is going.

When firms enter new markets or businesses, the way they structure their new businesses can result in greater complexity and less transparency. The increasing use of derivatives, forward sales, off-balance-sheet financing, complex contractual arrangements and new tax vehicles can genuinely confuse investors.

Investors should steer clear of not only companies, but advisors that lack transparency in their business operations, financial statements or strategies. Companies with inscrutable financials and complex business structures are riskier and less valuable investments, so by working closely with your investors’ goals, you put them in an empowered situation to make smarter choices.

The cause of poor transparency, however, is less important than its effect on a company's ability to give investors the critical information they need to value their investments. If investors neither believe nor understand financial statements, the performance and fundamental value of that company remains either irrelevant or distorted.

So how do you help take the guesswork out of financial analysis, both for you and your clients?

You may have seen the Morningstar Rating (also known as Star Ratings) table in various publications over the years. The ratings consist of an easily-identifiable five-star scale, designed to assist you with investment decision-making on funds and fund managers.

Morningstar adjusts for risk by calculating a risk penalty for each fund, based on 'expected utility' theory - a commonly-used method of economic analysis. The theory assumes that investors are more concerned about a possible poor outcome than an unexpectedly good one, and are therefore willing to give up a small portion of an investment's expected return, in exchange for greater certainty.

By comparing funds with their closest competitors, investors can focus on the top performers within a given category, without concern over whether the rating is penalising funds for sticking to an out-of-favour style. All categories, from small-growth to large-value, fall out of market favour from time to time.

The rise of smart beta, the intersection between active and passive management, allows investors to access portfolios that are constructed to outperform the market on a risk-adjusted basis. The proliferation of exchange-traded products (ETPs) and in particular exchange-traded funds (ETFs) in Asia is a notable investment trend that is benefitting investors. Transparent and superior quality, the ETF investment trend is here to stay, and will become even more attractive in the years ahead, in light of changing legislation.

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About Author

Nick Cheung  Nick Cheung is the CEO of Morningstar Asia

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