Category clutter

When is a bond fund, not a bond fund? For that matter when is an American fund, no-longer just an American fund? These are just some of the questions advisors and investors will have to grapple with Morningstar Canada rolls out its fund categories competing against those set by the Canadian Investment Funds Standards Committee.

The Chou Bond fund will be one of the funds at the centre of the debate over whether it is in a Canadian investor’s best interest to support two competing fund categories.

The fund, managed by Francis Chou, one of Canada’s most successful money managers in recent years, is just one example of a fund being classified differently by the CIFSC and Morningstar, which will launch its new fund classifications in October.

Under the CIFSC’s revamped categories, the Chou fund is listed as a Canadian Bond fund, while Morningstar thinks the fund’s risk and investment profile make it best compared to the high-yield fixed-income category.

David O’Leary, a senior fund analyst at Morningstar, says the fund is invested in distressed debt. Morningstar released a list on Thursday detailing where all of the funds fit into its new classification system. “It really is a junk bond fund or a high-yield bond fund,” says O’Leary.

Since the fund is less than a year old, the duel classification isn’t likely to have much of an impact on it. Still, the dispute illustrates just how advisors and fund managers may have to decide which fund category system they will use.

Classification is for advisors, according to Ralf Hensel, chair of the CIFSC and IFIC’s senior legal counsel.” Advisors have suitability obligations to their clients,” he says. “For them to recommend a particular fund that CIFSC puts in this category but Morningstar puts in a different — and a significantly different — category, then that’s a problem.”

The Chou fund won’t be the only one to move under the Morningstar’s new categories. Two of Canada’s largest dividend funds will no longer be measured against other Canadian dividend-mandated investments. Investors Dividend, Canada’s largest fund, as well as the TD Dividend fund will be placed in the Canadian equity-tilt category, while the majority of the Canadian dividend funds have been placed in the Canadian anchored equity, Canadian equity or Canadian high income equity categories.

On the other hand, the CIFSC puts the Investors fund in the Canadian balanced-equity focus category, and puts the TD offering in the Canadian income-balanced category.

According to O’Leary, these funds have significant bond holdings, which distinguish them from typical dividend funds. In the case of Investors, the fund is so big that they have trouble investing in equity so they’ve invested in bonds. “The truth is it’s probably a benefit for the fund itself to change categories, because those bonds represent a drag on the fund’s performance compared to other Canadian dividend funds that are fully invested in equity, which has been performing very well.”

Even if Morningstar and the CIFSC see funds in the same light, it might send some managers scrambling to modify their holdings in order to meet the new category requirements. Take the Dynamic American Value fund, whose objective, according to Morningstar, is “to provide long-term capital growth primarily by investing in U.S. companies.” Yet, both Morningstar and the CIFSC view it as a North American equity fund, which could force the manager to change the fund’s objective or adjust his portfolio, that is, if he or she doesn’t want the name of the fund to confuse investors.

Morningstar has made several changes to its fund categories based on the feedback it received since the initial release of its new methodology in May. One of the more notable changes is Morningstar’s decision to not to consider income trusts as a distinct asset class, but as a subset of the equity class.

Other changes include the addition of small and mid-cap equity categories, raising the threshold for the amount a fixed-income fund must hold to 95% from 90%, and rolling maple bonds into the Canadian bonds category.

Morningstar has also eliminated three income categories from its original proposal, namely the portfolio income, equity income and equity high-income. The fund-rating company has created the Canadian high income equity category to take their place.

The distinction within this category is that funds will be measured based on the yield of the underlying securities, rather than the distributions paid out by the fund. Morningstar found that there were too many inconsistencies between these fund structures, particularly in relation to the distribution policies of these funds, to justify maintaining separate categories.

Also of note is Morningstar’s decision against placing a hard limit on the number of funds needed to maintain a category. As a result, Morningstar-rated funds in these new small categories will not receive a Morningstar rating or a quartile ranking. In order for a fund to receive a Morningstar rating, a category must have 20 funds, while a minimum of 12 funds must be named inside a category in order to receive a quartile ranking.

Fund companies have until Saturday, September 30, to review the category membership. Any feedback received after the deadline will be taken into consideration for November.

Although the formal release of Morningstar’s categories would seem to nix any idea of reconciliation with the CIFSC, both sides remain optimistic. “All parties concerned seem to be of one mind when it comes to having a single set of categories,” says Scott Mackenzie, president and CEO of Morningstar.

While the CIFSC has made improvements to its own categories and increased transparency of the organization, the main issue is around the structure of the committee, particularly with the role that industry trade groups should have.

On one side, Mackenzie believes groups like the Investment Funds Institute of Canada and the Canadian Life & Health Insurance Association should participate on the committee, but they shouldn’t have voting privileges. On the other, Hensel argues that fund company participation does provide something useful to the group. He adds that fund data providers like Morningstar still hold the majority of the votes on the committee.

That could soon be water under the bridge. The committee’s progress since Morningstar’s departure has left the door open for talks to continue. While the progress at times has frustrated both sides, there is a sense of optimism that a solution can be worked out.

Scheduled meetings between the two sides this week are said to have gone well. Additional meetings were added for today.

Filed by Mark Brown, Advisor.ca, mark.brown@advisor.rogers.com

(09/21/06)