Morningstar/OBSR Qualitative Research: One Year On

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1 Morningstar/OBSR Qualitative Research: One Year On Dan Lefkovitz Director of Business & Operations, Pan European Research Team, Morningstar Europe Christopher Traulsen, CFA Director of Fund Research, Europe and Asia Morningstar Europe Richard Romer-Lee Research Director OBSR, a Morningstar company

2 Qualitative Fund Analysis at Morningstar: Established 1986 Underlying Principles No charge to issuer Positive & negative opinions Investor driven coverage

3 Qualitative Fund Analysis at Morningstar: Independent since 1986 Principles No charge for issuing analysis/rating Positive & negative assessments Coverage driven by serving investors Global knowledge; local expertise Report for transparency & education

4 Morningstar + OBSR = Better Together In-depth. Informed. Independent.

5 New Morningstar Fund Research Report 4-page report with data updated monthly Transparency: Clear reasons given for rating Elevate the debate beyond good fund/bad fund educate investors: What kind of fund is it? What are its portfolio biases? How can investors expect it to behave in different conditions? When is underperformance worrisome? What role can it play?

6 Global Research at Morningstar 200+ researchers worldwide Morningstar Global Offices Chicago Toronto Amsterdam Copenhagen Frankfurt London Madrid Milan Munich Oslo Paris Stockholm Zurich Mumbai New Delhi Cape Town Bangkok Hong Kong Seoul Shenzhen Singapore Taipei Tokyo Auckland Sydney Melbourne Quantitative methodologies team (PhDs, CFAs, MBAs) 100 equity analysts, 2,000 stocks 10 ETF & Closed End Fund Analysts New: Credit analysis & ratings 80 fund analysts; 4,000+ funds US: 30 fund analysts China: 6 analysts Australia: 10 analysts Canada: 7 analysts Europe & Asia: 25+ analysts OBSR: 14 investment professionals

7 Pan European & Asian Research Team 25+ fund analysts located across Europe (+ Hong Kong) London, Paris, Munich, Milan, Amsterdam, Madrid, etc. Local expertise, local languages, Pan-European perspective Senior Team: 6 members; 10 years average experience Global Analyst Network

8 Coverage through 7 May ,009 Funds Rated (463 Available for Sale UK) 104 Categories Elite 78 Superior 396 Standard 436 Inferior 79 Impaired 2 Not Ratable 1 Under Review 17

9 Funds rated from 125+ Fund Houses based in 10 markets Aberdeen, Allianz, AXA, Bestinver, BlackRock, Carmignac, Cazenove, Comgest, DJE, DnB NOR, DWS, Eurizon, F&C, Fidelity, First State, Franklin Templeton, Generali, Goldman Sachs, Holberg, HSBC, ING, Invesco, Investec, JOHCM, Kempen, KLP, Legg Mason, LODH, Lupus Alpha, MainFirst, Martin Currie, Metropole, Montanaro, Nordea, Odin, Optimix, Petercam, Pictet, Pioneer, Rensburg, Robeco, SAM, Santander, Schroder, Skagen, Sparinvest, Standard Life, Storebrand, Thames River, Threadneedle, Triodos, Tweedy Browne, UBS, Veritas.

10 Added Value of Qualitative Research Elite rated with 2 Stars: 3 Superior rated with 1 Star: 6 Superior with 2 Star: 27 Inferior with 4 Star: 7 Inferior with 5 Star: 3 Standard with 4 Star: 111 Standard with 5 Star: 44

11 Example: Fidelity Global Special Situations 1 Star Fund

12 Visibility & Commercial Impact 1,400,000,000+ downloads Through Morningstar Adviser Workstation, Direct, websites, as well as external platforms Private bank in Europe licensing reports on 160 funds for internal research & to display to bankers & clients Electronic Platforms: e.g. Fidelity Funds Network UK, Comdirect Germany Media Qualitative Ratings in tables: Investment Adviser, Investment Week, Portfolio Adviser, International Adviser Regular Quotes: Financial Adviser, Portfolio Adviser, Financial News, Investment Week

13 Qualitative Fund Analysis Philosophy Our fund analysis is bottom-up and driven by fundamentals There are many tools & datapoints to review risk/reward profile, BUT Backward-looking Can lead you to miss key risks or to ignore great funds Willing to be contrarian a fund does not have to be performing well for us to like it. Examples: Fortis Obam, Fidelity Global Special Sits

14 Five Qualitative Research Pillars People Process Parent Performance Price

15 Fund Review/Assessment Process Systematic Assessment of 5 Pillars Ratings Committee: Robust Peer Review Process Fund company does not review research report before we publish

16 Fund Review/Assessment Process Sources of information: Morningstar holdings and performance analytics Fund annual reports, prospectuses Global Analyst Consultation Fund Company Questionnaire Interviews with Fund Manager and Key Executives

17 Pillar One: People Manager experience: viewed qualitatively has manager seen a full market cycle? how relevant is past experience? Team support: does research structure dovetail with strategy and portfolio? Self-knowledge: does manager understand pitfalls of process, limitations of research? Incentive structure: how is the manager compensated?

18 Pillar One: People Case Study Manager of a UK Equity fund has 22 years of experience, is head of equity research at the fund house. Most of that came at the manager s present firm. There is no dedicated analyst support, but she focuses on UK largecaps, so the research is doable. She can also draw on work of other equity managers, each of whom has sector research responsibilities. She is responsible for covering financials and health-care stocks for the house in addition to running the fund and fulfilling her head-ofequities responsibilities. Her past experience includes macro work - this where we believe she can add the most value.

19 Pillar One: People Case Study But Fund is highly constrained in its ability to make sector bets Stock selection has been notably poor, especially in financials, accounting for bulk of fund s underperformance

20 Pillar One: People Case Study Conclusion: People rating is poor The manager s experience is extensive, but we think her skill-set is a poor match for the fund she is being asked to run. Moreover, stock selection is subtracting the most value in the manager s areas of specialty. Given the narrowness of the investable universe, we would not normally be too concerned about a lack of analyst support, but her lack of ability makes this a strong negative.

21 Pillar Two: Process Sensible strategy that reflects investment philosophy Style: e.g. deep value, aggressive growth Consistent application (stock analysis as aid) How active is it? Assess risks on fundamental basis Large position sizes Sector / geographic concentration Valuation Credit quality & duration Asset bloat

22 Pillar Two: Process - Case Study First State Global Emerging Markets Universe is large which is of concern. It is also one fraught with risk. Team focuses on rigorous bottom-up analysis, and professes to have a quality bias and a long-term orientation. Difficult to do with a large universe where information can be scarce. But staff and process are well matched to strategy: Use a quant screen to bring down the universe to a manageable size Team of 19 research professionals in Edinburgh, Hong Kong and Singapore, providing in-depth coverage on 350 stocks

23 Pillar Two: Process Case Study: First State Global Emerging Markets They look for firms with Sustainable long-term earnings and cash-flow growth Trading at reasonable valuations. To identify sustainable growth, they assess the management, the quality of a franchise, balance sheet strength, and corporate governance. Fully reflected in portfolio We find this is borne out in above average long-term forward growth rates, average to below average forward P/E ratios, and the team s past refusal to participate in hot momentum sectors Low turnover for a GEM strategy shows the fund adhering to longterm orientation

24 Pillar Two: Process Case Study First State Global Emerging Markets Is this research reflected in the portfolio in a way that it can have impact? Yes: portfolio construction is largely unconstrained Financials weight is only 1/3 the category average, Utilities weight is 4x the category average Fund is notably underweight in Energy and Materials, but overweight in Consumer Goods These types of positions are consistent through time South Africa and India are top two country exposures, but not too large circa 12% each Circa 100 holdings with top positions running at 5% Portfolio biases match what we would expect given the fund s strategy emphasis on higher quality, more predictable names and sectors

25 Pillar Two: Process Case Study First State Global Emerging Markets

26 Pillar Two: Process Case Study First State Global Emerging Markets What are the fundamental risks: Fund s unconstrained nature means its performance will deviate notably from benchmark and peers We expect it to underperform substantially in markets led by momentum or lower-quality fare But we also believe the assessment of fundamental risk by the team is strong and believe the emphasis on quality and sustainability of earnings will help the fund outperform in down markets

27 Pillar Two: Process Case Study First State Global Emerging Markets Conclusion: Process earns our highest score Strategy is robust and is consistently applied in the current portfolio and through time Even when their style is out of favour (as in 2005 and 2007), the managers stick to what they believe works in the long term The strategy employed is well matched to the resources at hand The fund s performance in different market conditions is highly consistent with what we would expect given the process Asset bloat needs watching, but no signs that alarm us yet

28 Pillar Four: Performance Not a simple screen evaluate performance within context of our expectations for fund given the investment approach Risk/return with a long-term emphasis Behavior in different market environments Separating skill from luck

29 Pillar Four: Performance Case Study First State Global Emerging Markets From our process discussion, we expected this fund to outperform in down markets and to lag in momentum-driven or low-quality led rallies. If the manager s thesis is valid, however, it should outperform through time.

30 Pillar Four: Performance Case Study First State Global Emerging Markets

31 Pillar Four: Performance Case Study First State Global Emerging Markets

32 Pillar Four: Performance Case Study First State Global Emerging Markets Fund is doing exactly what we would expect: Capturing most of the upside of the peer group with notably less downside risk.

33 Pillar Five: Price Expenses: a reliable predictor of long-term performance With all the uncertainty in investing, control what you can Trading costs Brokerage commissions Market Impact costs Structure of performance fees evaluated

34 Qualitative Research at Morningstar 24 Years of independent qualitative research = tremendous institutional knowledge Rigorous research into fundamentals, informed by global and local expertise World class data down to the individual security level to support research Quantitative research team lends further support as needed. Ratings Reports are fully transparent. They give a clear rationale for the rating and help users understand how to use a fund in a portfolio funds under coverage and rising. ETF & Investment Trust Research underway Investors come first

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