The Morningstar Category Classifications

Transcription

1 The Morningstar Category Classifications (for portfolios available for sale in Canada) Morningstar Methodology Paper 26 May Morningstar Research Inc. All rights reserved. The information in this document is the property of Morningstar, Inc. Reproduction or

2 President s Message Clear, consistent and rigorously monitored investment fund categories are essential to effective fund analysis. Robust categories are also crucial to the fund selection process used daily by investors and their advisors. Fund categories in Canada (as in other parts of the world) are not only used as an easy first filter in selecting funds for broader portfolios, but the attendant comparative statistics that categories produce are widely used for evaluating portfolio manager performance (and frequently their compensation levels). Fund categories matter. At Morningstar, we take the issue of well-defined and carefully monitored categories very seriously. Weak categories can cause all kinds of unforeseen problems for investors, advisors, and investment fund data suppliers. Indeed, many of Morningstar s proprietary analytics are adversely affected by inadequately monitored or poorly constructed fund categories. For example, Morningstar provides the industry s only set of survivorship-bias-free fund indices ideal for making relevant comparisons of mutual funds but these are needlessly distorted by the deeply flawed categories on which they are currently based. Star ratings, quartiles and other comparative statistics are also distorted by weak category systems. More importantly, the average investor is ill-served if he or she cannot rely on a fund s membership to a basic category to adequately describe the fund s most basic constitution and implied risk profile. A portfolio that is overwhelmingly invested in stocks should not be found in a bond fund category. A fund that invests primarily in large capitalization stocks should not be categorized as a fund that focuses on smaller capitalization stocks. To do so is to unintentionally mislead the investor and hinder the portfolio construction process, and potentially expose investors to undue investment risks. Why? Because at the most basic level, individual fund categories should have distinct risk profiles. Further, the members of a single fund category should exhibit reasonably homogeneous risk characteristics. Only in this way can investors (or their advisors) be confident about the benefits of combining funds from distinct categories for the purposes of diversification. Of course there are other considerations, but we feel the portfolio-construction concerns are perhaps the most important. Having been through the fund category development process a number of times, I can report to you that the process is not as simple and as clear-cut as it might first appear. Furthermore, different interested parties will have differing views as to the importance of one delineation over another. Bearing this in mind, I have asked Mr. David O Leary, Senior Analyst here at Morningstar Canada, to bring together a team of fund analysts and develop a blueprint for a better fund category system. Please find attached the first set of results from Mr. O Leary s team. It is a description of the Canadian fund category system that we currently propose. As with all such systems, there are aspects that are necessarily arbitrary to some degree, and as such may not be suitable for all purposes. Bear in mind that, although we employed a highly quantitative approach in arriving at these suggested categories, we also used some qualitative criteria. We took full advantage of the highly detailed and comprehensive holdings-based databases that reside here at Morningstar in order to come up with these suggestions. The processing of hundreds of thousands of data points is needed to determine category memberships on an ongoing basis. 2

3 We are distributing this document for comment to all interested parties, including fund analysts, fund companies, dealerships, media, investment fund data providers (including competitors to Morningstar), known investor advocates and of course, all interested individual investors via our site Feedback and constructive criticisms are essential to the successful rollout of the final category scheme (aimed for later this summer). We invite you to read the attached document carefully and provide us with any and all comments that you may have by June 23, We will then review all comments and incorporate improvements to the system as suggested through this feedback process. It is my sincere hope and desire that at the end of this process, Canadian investors will be much better served. In keeping with our Investors Come First corporate value, we will not be commercializing this fund category system. Instead, we will be providing complete transparency as to the system s construction and publishing the category membership each month as a free service to all interested parties. If you should have any questions or would like to speak further about this important project, please do not hesitate to contact me at (416) x229 or by at scott.mackenzie@morningstar.com Sincerely, Scott Mackenzie, President & CEO 3

4 Contents Category List 5 Highlights 7 Introduction 8 Methodology 9 Quantitative Screening 9 Qualitative Review 11 Appropriate Benchmarks 13 Income Categories 14 Hedge Funds 15 Category Definitions Money Market 16 Fixed Income 17 Portfolio 19 Equity 23 Specialty 28 4

5 Category List Asset Class Money Market Money Market Canadian Fixed Income Canadian Fixed Income Canadian Fixed Income Canadian Fixed Income Global Fixed Income High Yield Fixed Income Portfolio Income Canadian Portfolio Canadian Portfolio Canadian Portfolio Canadian Portfolio Global Portfolio Global Portfolio Global Portfolio Global Portfolio Life Cycle Portfolio Life Cycle Portfolio Life Cycle Portfolio Life Cycle Portfolio Equity Income Equity Income Domestic Equity Domestic Equity Domestic Equity Domestic Equity Foreign Equity Foreign Equity Foreign Equity Foreign Equity Foreign Equity Foreign Equity Foreign Equity Foreign Equity Foreign Equity Foreign Equity Morningstar Category Canadian Money Market US Money Market Short Duration Core Long Duration Inflation Protected Global High Yield Portfolio Income Canadian TAA Canadian Equity Tilt Canadian Neutral Canadian Fixed Income Tilt Global TAA Global Equity Tilt Global Neutral Global Fixed Income Tilt 5 Year Target Date 10 Year Target Date 15 Year Target Date 15 Year Target Date Equity Income Equity High Income Canadian Large Cap Canadian Small/Mid Cap Canadian Anchored Large Cap Canadian Anchored Small/Mid Cap North America US Large Cap US Small/Mid Cap Asia Pacific Rim Asia Pacific Rim ex-japan Japan Europe Emerging Markets Global Large Cap Global Small/Mid Cap 5

6 Category List (continued) Foreign Equity Sector Equity Sector Equity Sector Equity Sector Equity Sector Equity Sector Equity Specialty Specialty Hedge Fund: Equity Focus Hedge Fund: Equity Focus Hedge Fund: Equity Focus Hedge Fund: Equity Focus Hedge Fund: Arbitrage Hedge Fund: Arbitrage Hedge Fund: Arbitrage Hedge Fund: Corporate Life Cycle Hedge Fund: Corporate Life Cycle Hedge Fund: Corporate Life Cycle Hedge Fund: Macroeconomic Trends Hedge Fund: Macroeconomic Trends Hedge Fund: Macroeconomic Trends Hedge Fund Combinations Hedge Fund Combinations International Financial Services Natural Resources Precious Metals Science & Technology Real Estate Healthcare Labour Sponsored Investment Fund Specialty Equity Net Long Equity Net Neutral Equity Net Short Equity Variable Relative Value Arbitrage Convertible Arbitrage Fixed Income Arbitrage Corporate Event Driven Distressed Companies Merger Arbitrage Global Macro Emerging Markets Managed Futures Multi Strategy Fund of Funds 6

7 Highlights 3 Funds of funds will continue to be categorized alongside all mutual funds. 3 Life-cycle funds will be placed into one of four Life Cycle categories defined by maturity date. 3 Income trusts will not be considered a distinct asset class, but rather a subset of the equity class. As such, there will be no specific category for income trust funds. 3 Equity funds that hold at least 90% of their equity portion in domestic securities will be categorized as Canadian Equity, while those that hold at least 50% but less than 90% will be classified as Canadian Anchored Equity. 3 Income-focused equity and balanced funds will be categorized in one of three new categories: Portfolio Income, Equity Income, and Equity High Income. 3 Canadian and Global Portfolio funds will be divided into four categories: Tactical Asset Allocation Portfolio, Equity Tilt Portfolio, Neutral Portfolio, Fixed Income Tilt Portfolio. 3 Inflation Protected and Long Term Bond funds will have their own categories. 3 Additional small/mid cap equity categories will be created. 7

8 Introduction We are introducing the Morningstar Canada Category Classifications to help investors make meaningful comparisons between investment funds. The Morningstar classifications will employ a regular quantitative and qualitative screening process to ensure that both the category definitions and the constituent funds within those categories remain sound and useful to investors. The categories will help investors identify the top performing funds, assess potential risk, and build well-diversified portfolios. Morningstar will assign categories to all types of fund products, such as mutual funds, segregated funds, and funds of funds. We place funds in a given category based on their time-weighted holdings over the past three years, whereby more recent data is weighed more heavily. Morningstar s fund analyst team also reviews and approves all category assignments. If a portfolio is new and has no history, Morningstar estimates where it will fall before giving it a permanent category assignment. When necessary, Morningstar may change a category assignment based on recent changes to the portfolio. Category assignments will be reviewed monthly beginning on the 15th day of each month. Morningstar will notify each fund company of any proposed re-assignments and provide a one-week window for that company to provide any feedback on our proposed changes. The driving principle behind the classification system is that the distinctions between categories should be meaningful to investors and assist in their pursuit of constructing sound investment portfolios. Morningstar used the following criteria to help achieve this end: 3 Individual funds within a category invest in similar types of securities and therefore share the same risk factors, such as credit risk or interest rate sensitivity. 3 Individual funds within a category can, in general, be expected to behave more similarly to one another than to funds outside the category. 3 The aggregate performance of different categories should differ materially over time. 3 Star-rated categories have enough constituents to form the basis for reasonable peer group comparisons. 8

9 Methodology Morningstar found that the investment objective listed in a fund s prospectus often does not adequately explain how the fund actually invests. That s why we felt it was important to base our categories on what funds actually hold. The classification system has two stages: a quantitative screening process and a qualitative review. Morningstar is of the belief that investors are best served by categories that enforce a high degree of mandate purity. In short, equity funds should hold the vast majority of their assets in stocks while fixed income funds should invest overwhelmingly in fixed-income securities. We believe mandate purity helps investors construct better portfolios by avoiding overlap among funds from different categories. Some have argued that allowing managers to own a wider variety of securities within a portfolio helps to reduce portfolio volatility. While this is true, we believe that an investor can achieve this same diversification by combining funds. In keeping with Modern Portfolio Theory, we advocate that investors evaluate a fund s risk/return characteristics in the context of their overall portfolio, not on a standalone basis. The categories have been designed to prevent a blurring of the lines between funds that serve as building blocks in a portfolio and hybrid offerings that can serve as one-stop solutions. Those investors looking for one-stop solutions can find such offerings in the Portfolio and Life Cycle categories. Quantitative Screening The following pages illustrate the Morningstar quantitative screening process, which follows a Boolean logic approach to determine where a fund places according to the category definitions. We examine fund holdings for the trailing three-year period rather than simply examining a fund s most recent holdings. We believe a historical view better reflects how a fund typically invests. However, we recognize that historical averages may not persist and that more recent data is often more relevant. To this end, Morningstar calculates all holdings figures on a time-weighted average basis where more emphasis is placed on the most recent data. The most recent 12-month period receives a 50% weight, the next most recent 12 months receives 30%, and the oldest 12 months accounts for the remaining 20%. 9

10 Methodology (continued) Morningstar tracks investment funds on a comprehensive security-by-security holdings basis. Each security entered into the Morningstar database is assigned to one of 19 security types as outlined below. These security types can be grouped into four asset classes: Cash, Fixed Income, Equity, and Other. Asset Class Security Code Cash Cash and Short-Term Notes CH Fixed Income Mortgage-Backed Securities MS Bonds (bonds with a term of maturity less than one year are considered cash) Convertible Bonds Asset Backed Securities Equity Common Equities EQ Income Trusts IT Convertible Preferreds CP Preferreds PF Other Futures FT Options DP Other Derivatives OD Rights RT Warrants WT Bullion BU Commodities CM Real Estate RE Investment Funds IF Other Assets and Liabilities OT BO CB AS These four asset categories will be referenced throughout this proposal, as they form the basis for the quantitative screening process and for the rules associated with each category. Once a portfolio s securities are assigned to the above groupings, we adjust the fund s asset total to exclude its exposure to securities defined as Other. This re-stated total will be referred to as Adjusted Total Assets (ATA). ATA Total Assets Other 10

11 Methodology (continued) In most cases, we make one further adjustment to ATA to exclude a fund s cash holdings. We refer to this figure as Non-cash Adjusted Total Assets (NATA). It is calculated as follows: NATA ATA Cash Unless otherwise stated, any reference to a fund s percentage of Equity or Fixed Income will be a fund s Equity or Fixed Income exposure as a percentage of NATA. It is worth noting here that funds with more than 10% exposure to derivative securities classified as Other will receive manual categorization. Mutual funds use derivatives in a variety of ways including hedging, speculation, and creating synthetic equity or bond positions each of which results in different risk/return characteristics. Unfortunately derivatives cannot be treated uniformly. As such we believe it is only prudent to perform a detailed investigation of those funds with significant derivative exposure before categorizing them funds. All fund categorization methodologies that rely on specific, quantitative criteria are unavoidably arbitrary to a certain degree. The category boundaries we ve defined are based on a number of factors, including the current layout of the mutual fund landscape, empirical observation of fund characteristics, feedback from professional money managers, tax considerations, and generally accepted principles of portfolio theory. In recognition of the drawbacks of a quantitative categorization process, Morningstar will also implement a qualitative review. Morningstar s experienced fund analyst team will manually review any funds that straddle the boundaries between category definitions. This team consists of individuals who each hold advanced designations and/or degrees in finance (CFA, MBA, etc.). Qualitative Review The quantitative screening process is a very powerful first cut when categorizing funds. However, it suffers from the mechanical and unforgiving nature that is inherent in any quantitative measure. Judgment is often required for funds that do not fit the typical mould. Morningstar will employ a regular review and monitoring process with two primary goals: 1. To ensure that the membership of the existing categories meets the current category criteria; 2. To review and adjust the category definitions as investor needs and the Canadian investment fund landscape evolve. 11

12 Methodology (continued) The quantitative screening will be run on a monthly basis. The fund analyst team will review any funds that have crossed category boundaries to determine whether re-classification is warranted. Generally speaking, funds that straddle or cross category boundaries will not automatically be re-classified. The analyst team will investigate the fund s stated mandate, its historical investment behaviour, historical risk/return behaviour, and the manager s stated intent in order to determine the most appropriate category. If Morningstar does propose a re-classification, we will notify the fund company of the potential re-classification. The fund company will then have one week to respond with any feedback before we make our final decision. Any changes will be reflected in the data run that occurs in the following month. 12

13 Appropriate Benchmarks Once the final category boundaries and rules have been established, Morningstar will select an appropriate benchmark to assign to each category. One benchmark for an entire category of funds should be appropriate given the nature of the categories. Of course, there are always exceptions to every rule, and when possible, Morningstar will assign a new benchmark to specific funds that require one. 13

14 Income Categories While most categories are defined according to their asset allocation, funds that distribute a significant and steady stream of distributions for income-seeking investors have been grouped together. These income categories will help identify the funds that will meet the needs of those investors who depend on fund distributions for supplemental income. There are a total of three income categories: Portfolio Income, Equity Income, and Equity High Income. We do not make any distinction between Portfolio Income funds of varying asset mix or geographic exposure. Although the asset mix of Portfolio Income funds does vary, we believe the need to pay a regular distribution instills a certain discipline upon management to meet those income needs. In short, Portfolio Income funds tend to be more conservative. Furthermore, Portfolio funds by definition invest in a diversified mix of assets. This allocation of capital to various less than perfectly correlated asset classes is enough to keep the risk/return profile of all Portfolio Income funds more closely aligned. We do however make a distinction between Equity Income funds and Equity High Income funds. Unlike funds in the Portfolio Income category, these funds primarily invest in one asset class. As such, income-oriented equity funds tend to exhibit a larger range of volatility scores. We believe this is due in part to the emergence of the income trust market, which consists largely of small and medium capitalization companies. On the whole, income trusts tend to pay much higher distributions than dividend-paying equities, typically at the cost of higher investment risk. This distinction between Equity Income and Equity High Income helps investors identify those funds that pay significantly higher distributions at the cost of higher investment risk. In the quantitative screening process, no distinction is made between the various forms of income (interest, dividends, capital gains, and return of capital). In keeping with Modern Portfolio Theory, we believe it is beneficial for funds to take a total-return approach to investment management. It is worth noting that the majority of segregated funds do not pay distributions. As such, many segregated funds that replicate an income-oriented mutual fund may very well not belong to the corresponding mutual fund category. For example, XYZ Portfolio fund meets all the requirements for the Morningstar Portfolio Income category, but XYZ Portfolio Segregated fund (which is a clone of XYZ Portfolio) does not pay any distributions and thus does not meet the requirements for the Morningstar Portfolio Income category. The segregated version will therefore belong to a different category (e.g. Fixed Income Tilt Portfolio). The income categories are meant only for those funds, segregated or mutual, that pay a steady distribution to unit holders. No exceptions are made since this is the defining feature of the category. 14

15 Hedge Funds Funds that engage in alternative strategies (commonly referred to as hedge funds ) have been separated and categorized along different lines. These categories were developed for global use and are maintained by Morningstar s hedge fund team. The Morningstar Hedge Fund Categories are included in the attached appendix. 15

16 Money Market Funds Money Market funds invest specifically in cash or cash equivalent securities. The legal definition of Money Market funds can be found in National Instrument Canadian Money Market Canadian Money Market funds invest primarily in cash and cash equivalents. We adhere to the money market requirements stipulated in National Instrument U.S. Money Market U.S. Money Market funds invest primarily in cash and cash equivalents. We adhere to the money market requirements stipulated in National Instrument

17 Fixed Income Fixed Income funds invest at least 90% of their NATA in fixed-income securities. These funds are categorized along duration and credit quality lines, using the criteria that define the Morningstar Fixed Income Style Box. Please see the appendix for a thorough discussion of the Morningstar Fixed-Income Style Box, including a list of the credit quality and duration breakpoints used to assign style box scores. Credit Quality Breakpoints: Morningstar distinguishes between low, medium, and high credit quality fixed income securities, based on the criteria that define the Morningstar Fixed Income Style Box. The attached appendix includes the complete methodology for this measure. The calculated breakpoints are static and are based on commonly accepted distinctions in credit quality. Funds that have an average credit rating of AAA and AA are categorized as high quality, less than AA but greater than or equal to BBB are medium quality, and below BBB are categorized as low quality. Duration Breakpoints: Morningstar distinguishes between short, medium and long term fixed income securities, based on the criteria that define the Morningstar Fixed Income Style Box. The attached appendix includes the complete methodology for this measure. The calculated breakpoints were determined based on fund analyst research of various bond indices through time and in consultation with several leading Canadian fixed income managers. These breakpoints are static but will be reviewed as market conditions change. Style Box scores for funds are calculated each month. Note that for categorization purposes, we measure a fund s time-weighted average Style Box score over the trailing 36-month period. Short Duration Short Duration Fixed Income funds invest primarily in investment-grade fixed-income securities, such that they receive a rating of Short Duration and either Medium or High Credit Quality according to the Morningstar Fixed-Income Style Box. Funds with short durations will be less sensitive to interest rate changes than comparable funds with longer durations. These funds invest at least 90% of their bond holdings in fixed-income securities issued by Canadian governments and/or corporations. Core Core Fixed Income funds invest primarily in a diversified basket of investment-grade fixed-income securities, such that they receive a rating of Medium Duration and either Medium or High Credit Quality according to the Morningstar Fixed-Income Style Box. Also, these funds invest at least 90% of their bond holdings in fixed-income securities issued by Canadian governments and/or corporations. 17

18 Fixed Income (continued) Long Duration Long Duration Fixed Income funds invest primarily in investment-grade fixed-income securities, such that they receive a rating of Long Duration and either Medium or High Credit Quality according to the Morningstar Fixed- Income Style Box. Funds with long durations will be more sensitive to interest rate changes than comparable funds with shorter durations. Also, these funds invest at least 90% of their bond holdings in fixed-income securities issued by Canadian governments and/or corporations. Inflation Protected Inflation Protected Fixed Income funds invest at least 50% of bond holdings in fixed-income securities that adjust principal and interest payments roughly at the core rate of inflation. These inflation protected fixed-income securities tend to have long terms and high duration measures. Also, these funds invest at least 90% of their bond holdings in fixed-income securities issued by Canadian governments and/or corporations. Global Global Fixed Income funds invest less than 90% of their bond holdings in fixed-income securities issued by Canadian governments and or corporations. We do not delineate global bond funds along duration lines since there are relatively few global bond offerings in the Canadian mutual fund universe and even fewer global bond funds that, by mandate, invest heavily in short-term bonds. Furthermore, since the foreign currency exposure of these funds heavily influences their risk/return characteristics, global bond funds with similar duration scores do not necessarily exhibit a similar risk/return profile. High Yield High Yield Fixed Income funds invest primarily in fixed-income securities with a non-investment-grade credit rating, such that they receive a rating of Low Credit Quality according to the Morningstar Fixed-Income Style Box. There is no distinction along geographic or duration lines among High Yield Fixed Income funds. 18

19 Portfolio Portfolio funds invest anywhere between 10% and 90% of their NATA in equity securities and correspondingly between 10% and 90% in fixed-income securities. These funds were formerly referred to as balanced funds. We believe this conventional label is somewhat misleading since many balanced funds remain heavily skewed toward either fixed income securities or equities. The term Portfolio adopts a more recent industry tendency of referring to various one-stop fund solutions (such as funds of funds, life-cycle funds, and other wraps) as portfolios. We believe balanced funds are not materially different from a risk/return perspective than other fund-of-funds products with the exception of life-cycle funds, which we categorize separately. Portfolio funds are categorized along various lines. It is important to note that the following rules to distinguish between equity tilt, neutral, and fixed income tilt portfolio funds are based on percentage of ATA. We include cash in our calculation since cash is one of the asset classes that are actively used by many Portfolio funds. The 75% cut-off to distinguish between Canadian and global Portfolio funds is more lenient than the 90% requirement in the equity and fixed income categories. We believe that geography is a less important distinction for Portfolio funds since their risk/return characteristics are more heavily influenced by their asset allocation. Furthermore, Portfolio funds tend to either invest heavily in Canada or pursue a diversified global approach, thus, there is no need for a plethora of regional Portfolio fund categories (e.g. U.S. Portfolio, North American Portfolio, etc.) Enforcing a 90% Canada cut-off for Portfolio funds would relegate many Canada-heavy Portfolio funds to the Global Portfolio categories. We do not believe investors would be best served by such an approach. Portfolio Income Portfolio Income funds invest significantly in income-generating securities and pass that income along to investors in the form of distributions. Funds must meet two requirements to be included in this category: Distributions must be consistent, and they must be significant. Consistent distributions: In at least two of the past three calendar years, a fund must have paid at least three distributions. The frequency of the distribution was not completely arbitrary. Most investors tend to draw income monthly; however, we recognize that some may be content with quarterly distributions. Since income-oriented funds are under no legal obligation to meet certain distribution targets, even the best offerings may miss a distribution from time to time. As such, we require that income-oriented funds pay distributions in three months of a calendar year. Although this may seem a loose requirement, we find that many funds tend to either pay income very frequently or very infrequently. There are few funds that straddle this boundary. Those that do will be reviewed by the Morningstar fund analysts. 19

20 Portfolio (continued) Significant distributions: In two of the past three calendar years, the distribution yield must be higher than a benchmark yield. Distribution yield is defined as the sum of distributions paid throughout a calendar year divided by average daily net asset value per share (NAVPS). Benchmark yield is defined as the yield of a hypothetical portfolio, 50% of which consists of the average five-year GIC rate (according to the Bank of Canada survey) and 50% consists of the S&P/TSX Composite Index. Note: Both the five-year GIC and the average dividend yield of the S&P/TSX Composite index are calculated as the average of the 12 monthly observations for each corresponding calendar year. We use the five-year GIC as a proxy for the yield on a high-grade, medium-term bond. This serves as the benchmark for the fixed income portion of a portfolio fund. We use the average dividend yield of the S&P/ TSX Composite as the benchmark for the equity portion of a portfolio fund. Finally, we use an equalweighted average of these two benchmarks as a proxy for a moderate asset allocation split evenly between stocks and bonds. Portfolio Income funds are not defined along asset allocation or geographic lines. Canadian TAA Canadian Tactical Asset Allocation (TAA) funds actively vary their exposure to equity, fixed-income, and cash in order to capitalize on opportunities in the capital markets. These funds have a stated mandate to operate tactically or have demonstrated a clear history of tactical variations in asset class weights. Unfortunately there is no simple rule to distinguish tactical from strategic portfolio funds. Morningstar s method is to look at a fund s maximum and minimum equity weights over its life. If the fund s equity weight has varied by more than 15%, it will be flagged for review. Morningstar analysts will exercise judgment for funds that breach this rule. Canadian Equity Tilt Canadian Equity Tilt Portfolio funds are those that hold at least 55% of their ATA in equity securities. These funds employ a strategic investment plan where they monitor and maintain target asset weights and only allow slight deviations from these target weights. Canadian Neutral Canadian Neutral Portfolio funds are those that hold at least 45% but less than 55% of their ATA in equity securities. These funds employ a strategic investment plan where they monitor and maintain target asset weights and only allow slight deviations from these target weights. Canadian Fixed Income Tilt Canadian Fixed Income Tilt Portfolio funds are those that hold less than 45% of their ATA in equity securities. These funds employ a strategic investment plan where they monitor and maintain target asset weights and only allow slight deviations from these target weights. 20

21 Portfolio (continued) Global TAA Global Tactical Asset Allocation (TAA) funds actively vary their exposure to equity, fixed-income, and cash in order to capitalize on opportunities in the capital markets. These funds have a stated mandate to operate tactically or have demonstrated a clear history of tactical variations in asset class weights. Unfortunately there is no simple rule to distinguish tactical from strategic portfolio funds. Morningstar s method is to look at a fund s maximum and minimum equity weights over its life. If the fund s equity weight has varied by more than 15%, it will be flagged for review. Morningstar analysts will exercise judgment for funds that breach this rule. Global Equity Tilt Global Equity Tilt Portfolio funds are those that hold at least 55% of their ATA in equity securities. These funds employ a strategic investment plan where they monitor and maintain target asset weights and only allow slight deviations from these target weights. Global Neutral Global Neutral Portfolio funds are those that hold at least 45% but less than 55% of their ATA in equity securities. These funds employ a strategic investment plan where they monitor and maintain target asset weights and only allow slight deviations from these target weights. Global Fixed Income Tilt Global Fixed Income Tilt Portfolio funds are those that hold less than 45% of their ATA in equity securities. These funds employ a strategic investment plan where they monitor and maintain target asset weights and only allow slight deviations from these target weights. 5-Year Target Date These are life-cycle funds that mature in no more than five years. Life-cycle funds are those offerings that automatically adjust their target asset weights according to the remaining time horizon of the investment. These funds typically move from more aggressive (higher equity weights) to less aggressive (higher fixed-income and cash weights) as time passes. 10-Year Target Date These are life-cycle funds that mature in more than five years but no more than 10 years. Life-cycle funds are those offerings that automatically adjust their target asset weights according to the remaining time horizon of the investment. These funds typically move from more aggressive (higher equity weights) to less aggressive (higher fixed-income and cash weights) as time passes. 21

22 Portfolio (continued) 15-Year Target Date These are life-cycle funds that mature in more than 10 years but no more than 15 years. Life-cycle funds are those offerings that automatically adjust their target asset weights according to the remaining time horizon of the investment. These funds typically move from more aggressive (higher equity weights) to less aggressive (higher fixed-income and cash weights) as time passes. 15-Year+ Target Date These are life-cycle funds that mature in more than 15 years. Life-cycle funds are those offerings that automatically adjust their target asset weights according to the remaining time horizon of the investment. These funds typically move from more aggressive (higher equity weights) to less aggressive (higher fixed-income and cash weights) as time passes. 22

23 Equity Equity funds invest at least 90% of their NATA in equity securities. These funds are categorized along capitalization, sector, and geographic lines. See the appendix for a list of countries and their associated geographic regions. The Morningstar Equity Style Box is used to categorize funds along capitalization lines. Capitalization lines are only drawn for categories with a meaningful number of constituent funds, and where there is a clear distinction in the risk/return characteristics between Large and Small/Mid cap funds. Style Box scores are calculated each month. Note that for categorization purposes we measure a fund s timeweighted average Style Box score over the trailing 36-month period. It is worth noting that we do not delineate along investment style lines. Although it can be useful to distinguish between growth and value funds, we believe investors are best served by categorizing funds based on their capitalization bias. Due to the size of the available fund universe, we do not believe it is feasible to delineate along both lines. Any information provider who wishes to make a value/growth distinction is encouraged to do so in the form of a subcategory of one of the Morningstar Canada Categories. Morningstar will also provide these distinctions. Capitalization Breakpoints: The Style Box capitalization breakpoints are based on the premise that size breakpoints should be flexible and responsive to changing market conditions. Instead of using fixed dollar breakpoints to classify securities as Large Cap, Mid Cap, or Small Cap, the model bases that distinction on each stock s position in the cumulative capitalization. Large Cap stocks are those that together account for the top 70% of the capitalization of each geographic region; Mid Cap stocks represent the next 20%, and Small Caps represent the balance. Please see the appendix for Morningstar Equity Style Box methodology document, which includes a list of the current capitalization breakpoints used to assign Style Box scores. Equity Income Equity Income funds invest significantly in income-generating securities and pass that income along to investors in the form of distributions. Funds must meet two requirements to be included in this category: Distributions must be consistent, and they must be significant. Equity Income funds are not defined along geographic lines. Consistent distributions: In two of the past three calendar years, a fund must have paid at least three distributions. 23

24 Equity (continued) Significant distributions: In two of the past three calendar years, the distribution yield must be higher than the average dividend yield of the S&P/TSX Composite Index. Distribution yield is defined as the sum of distributions paid throughout a calendar year, divided by average daily NAVPS. Note: The average dividend yield of the S&P/TSX Composite Index is calculated as the average of the 12 monthly observations for average dividend yield in the corresponding calendar year. The figures are as follows: % % % Equity High Income Equity High Income funds invest significantly in income-generating securities and pass that income along to investors in the form of distributions. Funds must meet two requirements to be included in this category: Distributions must be consistent, and they must be significant. Consistent distributions: In two of the past three calendar years, a fund must have paid at least three distributions. Significant distributions: In two of the past three calendar years, the distribution yield must be higher than the average dividend yield of the S&P/TSX Composite Index multiplied by a factor of 2.5 (the Equity High Income Benchmark Yield). Distribution yield is defined as the sum of distributions paid throughout a calendar year, divided by average daily NAVPS. Note: The average dividend yield of the S&P/TSX Composite Index is calculated as the average of the 12 monthly observations for average dividend yield in the corresponding calendar year. The figures are as follows: % % % Equity High Income funds are not defined along geographic lines. Canadian Large Cap Canadian Large Cap funds invest at least 90% of their equity holdings in Canadian equity securities, such that they receive a rating of Large Capitalization according to the Morningstar Equity Style Box. 24

25 Equity (continued) Canadian Small/Mid Cap Canadian Small/Mid Cap funds invest at least 90% of their equity holdings in Canadian equity securities, such that they receive a rating of Small or Mid Capitalization according to the Morningstar Equity Style Box. Canadian Anchored Large Cap Canadian Anchored Large Cap funds invest at least 50% and less than 90% of their equity holdings in Canadian equity securities, such that they receive a rating of Large Capitalization according to the Morningstar Equity Style Box. Canadian Anchored Small/Mid Cap Canadian Anchored Small/Mid Cap funds invest at least 50% and less than 90% of their equity holdings in Canadian equity securities, such that they receive a rating of Small or Mid Capitalization according to the Morningstar Equity Style Box. U.S. Large Cap U.S. Large Cap funds invest at least 90% of their equity holdings in U.S. equity securities, such that they receive a rating of Large Capitalization according to the Morningstar Equity Style Box. U.S. Small/Mid Cap U.S. Small/Mid Cap funds invest at least 90% of their equity holdings in U.S. equity securities such that they receive a rating of Small or Mid Capitalization according to the Morningstar Equity Style Box. North America North America funds invest at least 90% of their equity holdings in North American equity securities. This category excludes any funds that meet the requirements of the Canadian, Canadian Anchored, or U.S. Equity categories. Asia Pacific Rim Asia Pacific Rim funds invest at least 90% of their equity holdings in Asian equity securities. This category excludes any funds that meet the requirements of the Asia Pacific Rim ex-japan or Japan categories. Asia Pacific Rim ex-japan Asia Pacific Rim ex-japan funds invest at least 90% of their equity holdings in Asian equity securities. Funds with more than 5% of equity holdings in Japanese equity securities are excluded from the category. 25

26 Equity (continued) Japan Japan funds invest at least 90% of their equity holdings in Japanese equity securities. Europe Europe funds invest at least 90% of their equity holdings in European equity securities. Morningstar s fund analyst team will review funds with a consistently narrow focus within Europe (for example, funds that invest in only one country or region in Europe) for possible exclusion. Emerging Markets Emerging Markets funds invest at least 90% of their equity holdings in emerging markets equity securities. Morningstar s fund analyst team will review funds with a consistently narrow focus within the emerging markets (for example, funds that invest in only one country or region in the emerging markets) for possible exclusion. Note: Funds that invest solely in the Latin American equity markets will not be included in the broader Emerging Markets category. We believe that funds that invest solely in Latin American markets have a different risk profile due to their geographic concentration than funds that invest in a wide range of emerging market regions. Given the small number of funds that focus specifically on Latin America, they will not receive their own category. These funds will be grouped with other Specialty funds. Global Large Cap Global Large Cap funds invest anywhere across the globe such that they receive a rating of Large Capitalization according to the Morningstar Equity Style Box. These funds do not meet any of the other geographic equity categories and have no formal restrictions that limit where they can invest. There is no formal rule that specifies how diversified Global Large Cap funds must remain. We recognize that global equity managers may choose to concentrate their portfolio for periods of time in a particular region as a tactical move to capitalize on perceived opportunities. Global Small/Mid Cap Global Small/Mid Cap funds can invest anywhere across the globe and receive a rating of Small or Mid Capitalization according to the Morningstar Equity Style Box. These funds do not meet any of the other geographic equity categories and have no formal restrictions that limit where they can invest. There is no formal rule that specifies how diversified Global Small/Mid Cap funds must remain. We recognize that global equity managers may choose to concentrate their portfolio for periods of time in a particular region as a tactical move to capitalize on perceived opportunities. International International funds invest anywhere across the globe with the exception of North America. These funds invest less than 5% of their Equity holdings in North American equities and do not meet any of the other geographic equity categories. There is no formal rule that specifies how diversified International funds must remain. We recognize that international equity managers may choose to concentrate their portfolio for periods of time in a particular region as a tactical move to capitalize on perceived opportunities. 26

27 Equity (continued) Healthcare Healthcare funds invest at least 90% of their equity holdings in the Healthcare sector according to S&P Global Industry Classification Standard (GICS ). Financial Services Financial Services funds invest at least 90% of their equity holdings in the Financial Services sector according to S&P Global Industry Classification Standard (GICS). Precious Metals Precious Metals funds invest at least 90% of their equity holdings in the Gold and Precious Metals and Minerals sub-sectors according to S&P Global Industry Classification Standard (GICS). Natural Resources Natural Resources funds invest at least 90% of their equity holdings in any combination of the following sectors or industries according to S&P Global Industry Classification Standard (GICS): Energy, Metals & Mining, and Paper & Forest Products. This excludes any funds that meet the definition for the Precious Metals category. Science & Technology Science & Technology funds invest at least 90% of their equity holdings in any combination of the following sectors or industries according to S&P Global Industry Classification Standard (GICS): Healthcare, Information Technology, Telecommunications, and any other technology related sub-sectors. This excludes any funds that meet the definition for the Healthcare category. Real Estate Real Estate funds invest at least 90% of their equity holdings in firms operating in the Real Estate industry. These funds will be manually classified since their securities in the real estate industry are considered financial services sector according to S&P Global Industry Classification Standard (GICS). 27

28 Specialty Specialty funds cover a range of unrelated groups of funds. As such, these funds do not receive star ratings even if there are enough constituent funds to otherwise calculate the rating. Labour Sponsored Investment Fund Labour Sponsored Investment Funds (LSIFs) are defined by federal and provincial statutes. As such, we do not examine their underlying holdings for categorization purposes. These funds receive special tax benefits for investing in Canadian venture capital. They usually require minimum holding periods and may charge fees for early redemption. Specialty Investment funds that focus on a geographic region or sector that does not belong to any of the previous categories will be considered specialty funds. Morningstar defines sector concentration through the use of the Industry Sector Concentration (ISC) measure. See the appendix for the ISC methodology. Any fund with an average ISC higher than 50 is considered extremely concentrated and will be a candidate for inclusion in a sector or specialty category. 28