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S&P fights to sell risk ratings on funds

How much should investors know about how risky their bond funds are or will be? And who should tell them?

Standard & Poor's, the bond ratings company, has been trying to get the regulatory division of the National Association of Securities Dealers to let fund companies publicize S&P's ratings of bond-fund risks in their sales literature. S&P, of course, already rates the risks of individual bonds, and that information finds its way into bond sales materials.

The NASD has turned S&P down twice, saying the ratings would be "predictive," meaning they would appear to predict future bond-fund risks, which the NASD does not allow funds to do. The ratings would be used in supplemental sales literature such as company-produced brochures, and not in advertising.

The measure also is opposed by the powerful Investment Company Institute, the trade group for the fund industry, for the same reasons and because, it says, investors would rely on the ratings "to an inappropriate degree."

But several groups say that more disclosure about risk would be better for investors, so they are supporting S&P's entry into the field. Those groups include the North American Securities Administrators Association, which represents state securities regulators, the Government Financial Officers Association and the American Association of Retired Persons.

If the NASD has turned it down twice, why is S&P getting a third shot? Clark Hooper, vice president for disclosure with the NASD's regulatory arm, said she and president Mary Shapiro met with S&P officials after they were turned down, to see if they could reach a compromise. It didn't hurt that Securities and Exchange Commission chairman Arthur Levitt has favored disclosure as long as it is not misleading.

Several fund companies already pay the high price _ $25,000 for the first fund reviewed and $6,000 for every other fund _ to get their products rated by S&P.

The industry view, stated in the conclusion of the Investment Company Institute's comment letter to the NASD, is that the ratings are "inherently flawed" because they are predictive, they reduce the question of risk to a single measure that focuses on short-term volatility, they are subjectively determined, they may quickly become outdated or stale, and they are subject to little regulatory insight.

The new process would include a rating of fund managements, accomplished through an interview process, and that gives the NASD regulators pause, Hooper said, because it is subjective and could not be duplicated for every fund. Fund companies also would be required to give S&P monthly oversight to determine if there were changes in the funds.

The reviews could lead to changes in funds' ratings, said S&P managing director Sanford Bragg. That could lead S&P to issue a release downgrading the funds, as S&P now does with bonds. There is a problem if a fund has produced sales literature with a positive rating that changes for the worse. There is no guarantee that the fund would pull the literature after a rating declined unless the NASD required it. And fund companies would not have to advertise all ratings received for their funds, good or bad.

It is the predictive nature of the ratings that worries Investment Company Institute chief counsel Paul Stevens. He said rankings and ratings by Morningstar and Lipper Analytical Services are based on historical performance and procedures that can be duplicated, as opposed to S&P's proprietary formulas.

Stevens said people have blind faith in Morningstar and Lipper rankings and cites a study that found that 91 percent of all new money going into stock funds went into Morningstar's top-rated five-star funds. That mirrors Stevens' concern that investors will use the S&P ratings as a basis for investment. Which is, of course, why funds with good ratings would buy them.

Morningstar president Don Phillips, whose company's ratings are widely advertised by funds receiving four and five stars, said: "The S&P ratings are designed to be advertising fodder. I would have no qualms if they were in the position of evaluating all funds, not only those that pay for them and get ratings that are flattering to them."

With SEC chairman Levitt pushing for more disclosure, and with ratings powerhouse S&P going up against that public darling, the mutual fund industry, it should be an interesting fight.

At the moment, the battle seems somewhat tilted toward disclosure, useful or not. If S&P wins and the funds can buy risk ratings, some will, some funds will feel they have to follow suit, and fund shareholders will pay the cost in minutely higher expenses.

If the industry wins, some investors will get a little less information.

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