Morningstar urges OSC to rethink on ad criteria

Share

Popular fund rater Morningstar Inc. is hoping to convince Ontario's investment regulator it has gone too far in its decision to ban the use of subjective awards in advertising.

Last month, the Ontario Securities Commission completed a review on the industry's advertising and marketing material and released new guidance around the use of industry investment awards in the promotion of mutual funds. Key to the issue is whether an award has quantitative or qualitative measures behind its methodology.

Quantitative measures would include raw numerical data – such as performance numbers – while qualitative measures would have more subjective content, such as the opinion of a jury panel.

As a result of the review, the use of awards in advertising are now subject to mutual fund regulation – National Instrument 81-102 – that prohibits fund companies from using any performance rating of a fund that is based partially on a subjective component.

Who is directly affected by the guidance isn't being spelled out by regulators publicly. Instead, investment fund managers are being encouraged to reach out to OSC staff regarding sales communications to discuss any questions.

The main investment award providers for Canadian funds are Morningstar Inc., Fundata Canada and Lipper Inc., which is a division of Thomson Reuters, and the selection process differs depending on the provider.

For starters, none of the three providers charges fund companies a fee to be considered for an investment performance award, but Fundata does have a fee to be listed on their research database, which currently has more than 17,500 Canadian funds.

For a separate group of submission-based awards (such as the Career Achievement Award), Morningstar requires a charitable donation to the MusiCounts organization, which helps fund school music programs.

While many investment awards are based solely on investment performance, for popular rating entity Morningstar it's a different story. These awards are more subjective than its peers. While the funds do have a minimum quantitative screen, there is a jury panel making the final decision – an aspect Morningstar CEO Scott Mackenzie says is a key component of what investors should be looking for in an award.

"The qualitative aspect is so valuable and we have the best analysts in the country evaluating these funds," says Mr. Mackenzie, who is currently meeting with the OSC to discuss the guidance.

The fund awards cover mutual funds, exchange-traded funds, hedge funds and pooled funds, with separate juries devoted to each product type. To qualify, all funds must have a three-year track record earned with the same investment mandate and under the same portfolio manager. The jury panel is made up of a combination of Morningstar fund analysts and third-party fund analysts from across the country.

Analysts are then asked to submit three nominees for each category, and a rationale to support each nomination. Analysts are not allowed to nominate funds with which they are in any way affiliated. An open discussion forum with all analysts is then held to review the nominations before the analysts cast their final votes.

"We are all for the quantitative screens – we have a whole business built around data-intensive information, and of course we look at performance – but let's also look at other factors such as fees, the manager process, style consistency and tax efficiency," says Mr. Mackenzie. "None of these other factors are considered in typical performance screens."

The practice of advertising investment awards has been used in the industry for more than two decades, and should require regulatory oversight, but not in the manner in which the OSC is currently doing so, says David O'Leary, former chair of the Morningstar Canadian Investment Awards Committee.

"It is perplexing that the OSC would interpret an award this way," says Mr. O'Leary. "The evaluation of these factors is inherently a subjective exercise. You simply cannot reduce the evaluation of something like the quality of a manager's investment process to purely quantitative factors."

Both the Fundata FundGrade A+ Awards and Lipper Fund Awards are based more on quantitative measures – determined by each entity's own proprietary rating system – and appear not to be affected by the new guidance.

"We have had a few questions coming from fund companies and we are communicating that, based on our interpretation, we are entirely quantitative and objective, so to us it appears we meet the requirements," says Reid Baker, director of analytics and data for Fundata.

Fundata ranks investment funds on a monthly basis using an alphabetical grading system from A to E. FundGrades of "A" classify the top 10 per cent of performing Canadian funds, while "E" classifications indicate the bottom 10 per cent.

At the end of the calendar year, all funds that have been in existence for at least two years will be handed an overall "GPA" score. The score is calculated by all monthly grades, with an A grade receiving a score of 4 and the E grade receiving a score of 0. Those funds with a credit score of 3.5 or higher will be awarded an A+ rating – which is commonly advertised to investors on how well a fund has performed.

The Lipper Awards recognizes all Canadian funds with consistent strong risk-adjusted performance relative to their peers. Awards for individual funds are handed out for three-, five- and 10-year periods, as well as for fund families with high average scores for all funds within a particular asset class or overall.