Monday Morning Memo: The Classification Conundrum

The classification of mutual funds is not as straightforward as one might think, especially since the regulation frameworks in Europe (UCITS) and other regions enable fund managers to use modern portfolio management techniques to achieve their investment goals. As an answer to investor demand for transparent peer groups that contain funds with the same investment objective and approach (in order for investors to run meaningful performance and/or risk comparisons), Lipper has released another series of fund classifications. The August 2014 listing of Lipper classifications can be reviewed here, but in this article we take a closer look at the general challenges faced by a fund classification committee and how Lipper has responded to some of the changes in the funds industry since the 2005 launch of the Lipper Global Classification (LGC) series.

The good old days

REUTERS/Athar Hussein

Our LGC scheme has doubled in size—from around 200 to more than 400 sectors—over the last nine years. The original scheme was wholly driven from the asset base of the fund, with further divisions by regional and currency foci. This broad starting point reflected the way most funds were managed at that time. Performance “success” was defined relative to an asset-based benchmark, regardless of whether the product was passively or actively managed. At that time the LGC committee had a comparatively easy task to fulfill its mission of providing the funds industry homogenous or “like with like” sectors to facilitate comparisons and build appropriate Lipper benchmarks for performance measurement.

The years since 2005 have seen huge changes for the investment industry as a whole, with financial institutions being rocked to their core by global or regional instability. In this period we have seen rapid technological developments, and the speed and availability of market information have never been faster or greater. The complexity of financial instruments has fast outpaced regulation and control. Insufficiently regulated markets are open to exploitation by savvy individuals who seek opportunities in the “gaps.” Whatever your opinion of the way markets should operate, some things are undeniably evident after 2005: unprecedented market instability, unprecedented levels of volatility, and unprecedented high correlations in global equity markets. These have significantly damaged investor portfolios and have led to subsequent responses by regulators and the funds industry to reclaim some systematic control.

A new era begins

Lipper started to witness new retail funds that had no market benchmark but instead aimed to meet a certain goal. Some products had stated “time horizons” that could be as short as a year or were based on a market cycle. These products generally hinted in their name or objective at a desired outcome that was independent of market conditions. The goal might be to achieve “absolute return,” “target return,” or “total return” or to meet a certain liability target: cash plus, inflation plus, retirement income, monthly income. Lipper’s LGC simply had no home for these funds, so in 2007 we created some of the first absolute return sectors as a kind of temporary staging area for this new breed of funds (see also Monday Morning Memo: Diversity Within Absolute Return Funds, by Jake Moeller, July 28, 2014).

For retirement target maturity funds with “glide path” allocations we provided new sectors grouped by maturity date and currency. In 2009 we started to measure the outcomes of absolute return funds and categorize them—with a historical value-at-risk metric—according to their ability to avoid losses. This is probably the best example of a difficult decision for the LGC committee, because categorizing in this way makes no indication of the strategy and does not measure every possible outcome. It also encourages return comparisons that might not be appropriate. But, given the impact of doing nothing, the process starts to make sense. Nobody wants to see a fund in an “unclassified” or “other” sector. Comparing apples and pears is just not fair! Sometimes the role of a classification committee is to provide a helpful starting point for further analysis. It is impossible to answer immediately every question or satisfy every need.

The appetite to avoid losses in the frequent and significant market downturns led inevitably to greater permissible use of derivatives in regulated funds under the new UCITS product directive (UCITS III). New products with shorting capabilities poured into the market, looking and sounding suspiciously like hedge funds but with daily liquidity and gearing/exposure restrictions to prevent any potential for massive losses. They were not comparable with hedge funds; these were a brand new fruit. So, the LGC committee provided hedge-like sectors in 2012, using the popular industry terminology of “alternatives and strategy funds.” For example: Alternative Long-Short Equity US became an obvious LGC creation, once sufficient funds had been launched.

Our classification committee has faced many other challenges. Fund terminology unfortunately can be led by marketing. Is a mixed-asset flexible fund different from a dynamic unconstrained absolute return fund, a multi-asset fund, or an alternative global macro fund? That is a rhetorical question, but not for the classification committee. (I can hear the clamor of boisterous debate just writing this!) Decisions must be justified and guidance for classification analysts must be clear and rules-based. Too many overlapping or new sectors can split traditional or existing comparisons, reduce total assets under management in a peer group, and disrupt the meaning and historical comparison of ratings and averages.

Outcome-oriented investing is arguably our latest challenge. The funds must be identified and grouped, but they are not necessarily comparable. A multi-asset managed-risk product might measure its success on consistency, while it may not be a leader of the group on total return. This is where our long-established Lipper Leader Ratings feature heavily. They are intrinsically linked to the LGC. They measure not just one outcome, but many. The classification committee seeks to categorize funds so that appropriate Lipper Leader Ratings can be generated for Total Return, Consistent Return, Preservation, and Expense.

Please feel free to review the documentation for Lipper Global Classifications 2014 here.