Seg fund selection gets much needed coverage

Morningstar Canada’s PALTrak has been an indispensable tool for advisors looking for current information and analysis on the mutual fund industry. With its inclusion of a seg fund module for PALTrak, the implications for how advisors industry-wide choose these products could be significant.

One of the great disconnects in the investment industry is comparing a mutual fund to a seg fund. There have been great mutual funds that have overpriced insurance wrappers, so choosing a seg fund purely based on an underlying fund is not the best way to make a selection. By the same token, there are some great seg fund contracts that have some questionable underlying funds.

The take-away is that seg funds are a class of investment tools by themselves, and recognizing this, Morningstar Canada is hoping its new module will help advisors make a clear, apples-to-apples comparison amongst the more than 3,000 seg funds now available.

Advisors who are not entirely comfortable with the recommendation made by their wholesalers on these products have had limited resources to compare seg fund products — it can be done, but it takes time.

The PALTrak Segregated Funds Module features a single source of contract-level data, such as automatic and manual reset options and guarantees, maximum age allowed to purchase, guaranteed minimum withdrawal-specific data, and guarantees on death and maturity. It also includes its traditional fund-level data, including performance, asset allocation and proprietary tools like the oft-quoted Morningstar Rating, which is out of five stars.

“There is no centralized database or research tool designed for seg funds on a contract level basis. Advisors can search PALTrak based on underlying fund performance and MER, but also on a contract level where you’re talking about contract options or death benefit guarantees. Advisors rely on information folders, company websites and wholesalers to get this data,” says Richard Nguyen, product development manager for advisor products, Morningstar. “It’s a good idea to launch something like this now because seg funds, specifically GMWB products, are quite popular, but also very complex. This tool will capture things in an advisor-friendly way, and allow advisors to explain funds to their clients in 30 seconds as opposed to going through an information folder, which can take much longer.”

Nguyen says using the search filters will allow advisors to create a shortlist of products that meet their specific selection criteria.

“We’ve collected contract level data, making the data points searchable by the filter option. For example, if you’re only looking for funds that have reset options that are automatic versus client-initiated, you want an MER lower than 3%. Combined with a Morningstar rating of five stars, you could do all that,” he says.

Arguably, the feature that will have the broadest industry-wide implications is the seg fund-specific analysis from Morningstar’s team of independent analysts. There have been very few independent sources of analysis on seg funds. This adds a level of transparency that’s been lacking with seg funds.

Brian O’Neill, senior fund analyst with Morningstar Canada, says the star rating for segregated funds is similar to the one for mutual funds, and is entirely quantitative. Already well versed in most of the underlying funds offered, analysts will be increasingly focusing on the contract feature of the funds.

“We’ve really just started, so we only have a handful of seg funds that are covered right now. We plan to grow that in 2009. We’re tackling things a little bit differently from how we do regular mutual funds, in that we are concentrating on the contract itself a little bit more than the management of the funds,” he says. “When you’re looking at seg funds versus mutual funds, really the key feature of the seg fund is the maturity guarantee, which is effectively like buying a put on your fund. There’s a cost associated with that.”

O’Neill is hopeful Morningstar’s analysts will be able to offer an objective cost-benefit analysis of whether a particular seg fund is worth the fees, especially in comparison to other products on the market.

“We’ll look at the difference on the MER versus the underlying fund. Assuming that portfolios are very similar — which is often the case — we’ll explain how much it costs in order to have that principal guarantee,” he says. “[Well also compare] how much money you have to set aside to purchase a [comparable] strip bond or we may look at the cost of a comparable seg fund and what the implied cost of the put option would be.”

Nguyen says offering the contract-specific information is a key feature that MGAs and insurance advisors have been asking for. You need an insurance licence to sell seg funds, but not a security license. Therefore, there is a contingent of insurance-focused advisors who only sell seg funds. Morningstar will be selling a stand-alone seg fund module, directed at insurance advisors.

“If you were to buy it as a stand-alone version, you wouldn’t have a lot of the technical functionality that exists in the regular PALTrak. You would have your basic performance, and then you would have all the contract level information,” he says. “The communications we’ve had with MGAs has suggested we really focus on the contract level information and not as much the mutual fund info.”

(12/19/08)