In the UK, unlike the situation in many other countries, industry representatives and data providers define and monitor the classification into sectors of like funds.
The Investment Association sector classification is aimed at the needs of the consumer. Customers have a legitimate desire to be able to compare like for like. The primary purpose of the Investment Association's approach to sector classification is to provide groups of similar funds which can be fairly compared by consumers and their advisers. The integrity of the Investment Association sector classification system is overseen by the Sectors Committee ("the Committee"). It provides guidance to Investment Association members and data providers on the appropriate classification of funds.
As far as possible the Committee seeks to ensure:
Uniformity - in the preparation and presentation of data (at the same time recognising that the data providers are not bound by the Committee's guidance and that they are free to pursue their individual commercial objectives);
Continuity - on the premise that frequent change is confusing to users unless there is a compelling reason for it and that change is over time likely to invalidate the meaningfulness of the data;
Intelligibility - it is the way in which data is interpreted that ultimately determines its effectiveness; and
Independence - measurement comparisons should be independent of commercial considerations.
Areas falling within the Committee's remit include:
The number, type and definition of sectors, including those currently in existence and any changes necessary for the future;
Monitoring of sectors, to ensure that as far as possible funds included in a sector comply with its definitions;
Allocation of new funds into the appropriate sector;
The need to be able to identify groups of funds, which whilst meeting specific sector criteria, have additional similarities which investors or their advisers may legitimately wish to compare e.g. tracker funds, ethical funds;
To advise on a uniform method of calculation of yield both for sector definition purposes and for publication/disclosure more generally;
To co-operate with regulators on the drafting of rules, which affect areas within the remit of the Committee and to co-ordinate the industry's response to such rules as appropriate.
Any significant matters deemed to be of relevance to Investment Association members as a whole, e.g. the creation, deletion or amendment of sectors, are referred to the Investment Funds Committee for discussion after consultation with the Membership.
In dealing with matters concerning an individual company, the Committee will endeavour to reach agreement directly with that company. The Chairman of the Committee will ultimately rule on any matters in dispute.
The Committee is made up of representatives of a cross-section of Investment Association member companies and the major fund data suppliers.
Members of the Committee are chosen to ensure there is a balance of investment management, marketing, statistical and operational expertise around the table. When a member resigns he may be replaced with an individual from the same organisation with the requisite expertise. An individual from a different management group may be approached at the discretion of the Chairman or the committee. Rotation and tenure are currently discretionary.
Fund management company representatives on the Committee provide a wide range of types of industry expertise well able to address complex issues that may arise.
The data providers have a strong incentive to ensure that all performance comparisons are fair and that no one fund provider is advantaged in the approaches being adopted. The involvement of all the main data providers helps to ensure consistency in sector definitions.
The data providers can help to influence the way in which third parties, specifically journalists, present performance figures. This again helps to ensure that comparisons are more likely to be fair and objective.
Whilst the detail of the Committee's work in progress remains confidential until it is in a state to be delivered to member companies, members of the Committee are asked to ensure that they actively solicit the views of their in-house colleagues.
Meetings are held on a monthly basis.
Investment Association sector classification
The Investment Association classification of funds is based upon a matrix of two dimensions. Most fund objectives set out a targeted primary outcome and the eligible assets that can be used to deliver that outcome. In the matrix schematic sectors are slotted in to reflect this two dimensional approach. The structure is set out in the classification system diagram.
The Committee believes that typical retail investors concentrate either on whether the fund provides an immediate (or growing) level of income, (i.e. in some sense the fund is being bought for the immediate cash flow it is likely to generate), or on whether it seeks to achieve capital growth/total return (or capital protection).
The distinction between income and capital is not absolute. There are various ways of turning income into capital or vice versa. For example, deducting charges from capital rather than from income boosts income with an exactly equivalent reduction in expected capital growth. Also, many retail investors select income funds, but reinvest that income, as if the fund were effectively being used to achieve capital growth.
However, a clear distinction between income and capital growth is normally made in fund managers' marketing literature, and seems to exist in most retail investors' minds. This distinction is often, but not always, directly linked to the fund's underlying assets (e.g. funds investing in bonds are generally perceived as providing high income, whilst funds investing in cash are generally perceived as providing high capital protection).
The second differentiator in the classification system is the type of asset in which the fund invests, e.g. a UK equity fund is taken to be different from one that invests primarily in overseas equities. Geographical or asset type grouping are used to delineate major sectors that may be relevant from a customer perspective.
The Committee believes that from the perspective of the retail public it is important to have a manageable number of comparable groupings standardised across the industry. In addition, there needs also to be a minimum number of funds within any one grouping to permit ranking of funds within a group to be a relevant and useful measure for consumers.
Some groupings may be so small that it is not practical to define a full sector for them in isolation. These funds are categorised in the Specialist sector which acts as a ‘catch all' sector.
The nature of the Specialist sector is such that performance comparisons of an individual fund against the sector as a whole, including rankings of funds, are inappropriate. However, the data providers may flag funds within the Specialist or other sectors that share a particular investment theme or universe - these flags may be useful to financial advisers and more sophisticated investors. However, in general, the Investment Association does not set out to monitor membership of flagged sub-groups within a sector.
Management of the classification system
The market for funds is not static. Investment tastes change, often in response to market developments, and such changes need to be reflected within the classification system. The Committee reviews the classification system annually, removing sectors where there are too few members to permit fair comparisons to be made, and splitting out new sectors in circumstances where new funds have emerged in sufficient numbers and where their separate identification would be useful to consumers.
It also reviews the definition of individual sectors to keep these abreast of market developments. For example, there is no unique definition of small cap companies. An initial definition based on a % of market capitalisation may need to be changed if market developments reduce the number of companies meeting that criteria and this overly constrains investment.
The Committee has typically opted to maintain an 80/20 split for the focus of a portfolio's assets in sector definitions. This permits an appropriate level of flexibility for the practical day-to-day operation of running a portfolio. It would be unhelpful to have funds flip-flopping between sectors merely on the basis for example, of a short-term currency shift.
The Committee has set in place a system to rigorously monitor individual funds adherence to the sector definitions. This is based upon portfolio holdings information and, where appropriate, e.g. for income funds, other data. Funds are monitored monthly against the criteria set by the appropriate sector definition (for example against maximum or minimum % of an asset class).
The Committee's remit is to ensure that funds marketed on the basis of Investment Association sectors actually meet the criteria set for those sectors.
Data submission for sector monitoring
Morningstar collect portfolio holdings data from management groups and analyse individual funds' compliance with sector definitions in order to facilitate independent third party sector monitoring
For groups that do not submit data, a warning letter will be sent out after the third month of non submission. If the group fails to report subsequent months data, their funds will be removed from Investment Association sectors.
Once removed, management groups will have to demonstrate at least 3 months compliance before having to resubmit their fund details to the Committee for readmission. Groups are required to provide missing historical data to Morningstar. Failure to provide full data will affect track record retention and may prevent a return to the sector.
Breach notification guidelines for funds exclusion and re-entry into Investment Association sectors
Where a fund has been in breach of its sector parameters for 3 consecutive months (or 5 months out of 12 in a 12 month rolling period) a letter will be sent from the Investment Association to the management group setting out a window of 1 month for the group to acknowledge receipt.
The management group then has 2 choices:
-If they intend to comply with the sector in which they reside then they have a 3 month window from the date of the letter to achieve that. They also have to make a commitment to long term adherence.
-If the response is that they will not be getting back into compliance or there is no response in the one month window then the fund should be removed from the sector as soon as possible.
The fund may be placed in a sector of the Committee's choice or unclassified. Return to the original sector is not permitted in a 12 month period.
Readmission to a sector once a fund has been removed and the 12 month period has elapsed will be subject to the discretion of the Committee.
The guiding principle in relation to performance issues is that the data provided to the consumer must be clear, fair and not misleading. Historically, the majority of issues that arose were in relation to the retention of performance history when funds merged and/or when funds wished to be reclassified in a different sector.
The Sectors Committee is of the opinion that in general a fund should retain its performance history. Pre July 1 2011, in instances where a significant restructuring of the portfolio took place, the Committee would carefully review that position case by case. Typically, restructurings would only be deemed significant if there were changes which required a unit holder meeting, or where specific notice of the changes were sent to investors in the fund in question. However, new regulations governing the production of a Key Investor Information Document (KIID) for UCITS funds from July 1 2011 lay down rules on the presentation of past performance data, the use of simulated data in past performance and the retention of performance in relation to a merger.
In order to avoid confusion by the proliferation of a number of track records in relation to the same fund or inconsistent presentation of performance data in relation to non UCITs funds, the Sectors Committee no longer makes decisions on the retention of performance history for any authorised funds. The presentation of past performance should therefore be based on Articles 15-19 of Commission Regulation (EU) No. 583/2010 of 1 July 2010 as regards key investor information.
Article 2(1)(p)(i), (ii) and (iii) of Directive 2009/65/EC refers to mergers.
Fund conversions to OEICs
Whether created out of one or more unit trusts, the OEIC should have a continuous single price history from inception of the primary unit trust, or commencement of its present day objective. In order to ensure there is no performance boost or loss in moving from a bid to a mid basis, a conversion factor for each fund needs to be calculated. This is achieved by taking a notional quoted price of the OEIC as a ratio of the last quoted bid price as a unit trust, the valuation point being the same. When a performance period straddles the conversion date, this factor would then be applied to each historic price of the fund prior to conversion.
Where a unit trust converts to an OEIC offering multiple share classes, history can be created for new classes with different charges, based on the performance of the original unit trust. Where a retail class is added to an institutional fund, the history applied to the retail share class should be adjusted to take account of charges. The same principle applies when a new share class is launched in an existing OEIC at a later date.
The repatriation of an off shore fund offers a further instance where to ensure the relevance of the performance history going forwards, adjustment of the previous history will be required, for example to take account of differences in charges, fund expenses and tax, etc.