Morningstar Submission to Review into the Governance, Efficiency, Structure and Operation of Australia's Superannuation System

Transcription

1 Morningstar Submission to Review into the Governance, Efficiency, Structure and Operation of Australia's Superannuation System Phase Two: Operation and Efficiency 14 December 2009 Prepared by: Morningstar Australasia Pty Ltd Phone Level 36, Australia Square Fax 264 George Street Sydney NSW

2 Executive Summary Morningstar is pleased to respond to the Phase Two Operation and Efficiency Issues Paper of the Review into the Governance, Efficiency, Structure and Operation of Australia's Superannuation System ('Super System Review'). In particular, we address the following sections of the Issues Paper: The Typical Australian Default Investment Option Investment Returns After-Tax Reporting Disclosure Standards for Performance Fees Morningstar would be pleased to provide any additional information or clarification at the Super System Review's request. About Morningstar Morningstar Australasia Pty Ltd is a unit of Morningstar, Inc. (NASDAQ: MORN), a leading provider of independent investment research in North America, Europe, Australasia, and Asia. The company offers an extensive line of Internet, software, and print-based products and services for individuals, financial advisers, and institutions. Morningstar provides data on more than 325,000 investment offerings, including stocks, mutual funds, and similar vehicles, along with real-time global market data on more than four million equities, indexes, futures, options, commodities, and precious metals, in addition to foreign exchange and Treasury markets. The company has operations in 20 countries and minority ownership positions in companies based in two other countries. 2 Morningstar Australasia Pty Ltd 14-Dec-09

3 Response to Issues Paper The Typical Australian Default Investment Option Is it appropriate that the typical default investment option treats all members as having the same investment horizons and risk appetite? Target date, glide path or lifecycle funds have gained popularity overseas and have been recommended, in at least one report, as the best default investment option. In the United States, about two-thirds of 401(k) plans offered lifecycle funds as an investment option at year-end Should a lifecycle fund, or some similar model, be mandated as a default investment option? Morningstar does not believe that default investment strategies should be mandated. Trustees should continue to be in a position to select the most appropriate strategies for the members of a superannuation fund, including target maturity funds as appropriate. Morningstar has extensive experience with target date funds in the United States (including well-recognised research from Ibbotson Associates), and we direct the review committee to the following documents for additional background. 'Lifetime Asset Allocations: Methodologies for Target Maturity Funds (Summary)' (1 May 2009) 'Morningstar Target-Date Series Research Paper: 2009 Industry Survey' (9 September 2009) 'Morningstar Target Date Fund Series Ratings and Research Reports Methodology' (30 October 2009) Investment Returns Is the investment performance data about super funds currently published by APRA adequate? APRA uses rate of return to measure fund investment performance. Is this the most appropriate fund performance metric? There has been debate on the need for APRA to publish investment returns for individual investment options within super funds. Should this be done, bearing in mind that super funds can have many individual investment options and that there is no consistent terminology or standard for determining what asset allocation parameters each option should have? Should APRA persist in trying to identify an investment option that is comparable across all super funds? Would it assist consumers and policymakers if there were standardised definitions of asset classes and investment options used in super funds? If so, is the industry capable of generating those definitions within a reasonable time, or should definitions be statutorily prescribed and funds and fund managers be required to report against those definitions? There has been a suggestion to use a risk adjusted value added (RAVA) metric to compare and rank super funds, rather than to compare individual investment options. Would this performance metric provide useful comparative information? Does this comparative information justify the collection and possibly the publication of quarterly asset allocation data? Apart from returns, what other comparative information is useful for the industry and consumers? On what basis and how would that information be used? Can different data be obtained to enable better comparisons across superannuation products and providers? 3 Morningstar Australasia Pty Ltd 14-Dec-09

4 Should the industry adopt standard terms and definitions with respect to performance metrics to ensure comparability? In particular, how can trustees and their service providers be incentivized or compelled to make fees and charges more transparent and comparable for members? Morningstar does not believe that the performance figures published by the Australian Prudential Regulation Authority to date are as useful as they could be for individual investors. We believe that it is important for investors in both superannuation funds and managed funds more generally to be able to compare individual options which have similar investment strategies and underlying asset allocations. Morningstar operates a fund classification system which we use to categorise approximately 11,000 individual superannuation, managed fund, and pension options in Australia. (The methodology for this classification system is attached as an appendix to this submission.) Additionally, once a fund is classified we also devote considerable resources to capturing other information which helps trustees, investors, and other market participants to understand fundamental characteristics including market-cap and investment style for sharebased funds, and credit quality and duration for income options. We also believe that the requirement should be for investment managers to publish quarterly asset allocations at a minimum. Many investment managers currently disclose this information to Morningstar voluntarily on a monthly basis, and we advocate regular, comprehensive disclosure of portfolio holdings more generally (refer section below). Morningstar would be willing to work with the Australian Securities & Investments Commission and other bodies to explain our methodology and its benefits After-Tax Reporting What impediments (if any) are there to an industry standard on after-tax reporting of investment returns? Morningstar embarked on calculation of after-tax returns for unit trusts in Australia in (The methodology for this calculation is attached as an appendix to this submission.) For simplicity, we chose the highest marginal tax rate for calculation purposes, and are currently reviewing system requirements to also calculate after-tax returns at the superannuation tax rate. Investment & Financial Services Association Guidance Note No Product Performance: Calculation of After-Tax Returns, released in June 2008, also provides guidelines to standardise practices, procedures, and terminology relating to calculation of after-tax returns. Generating after-tax returns that facilitate cross-sectional analysis of investment managers is problematic because of the number of assumptions required. Morningstar took the view that the benefits of having a measurable, consistently-applied basis far outweigh the imprecision associated with any particular after-tax return calculation methodology. By focusing on after-tax returns, we aimed to improve investment manager behaviour in areas including high turnover, high associated brokerage costs (borne ultimately by the end investor), and increased capital gains tax liabilities. 4 Morningstar Australasia Pty Ltd 14-Dec-09

5 While the Morningstar and IFSA methodologies were aimed at product calculations, we believe they form a strong base from which to build a methodology that could be applied equally to individual accounts for superannuation funds. As Morningstar discovered, it is one thing to create a standard and to program calculations, but another to get the data necessary to undertake these calculations. We now believe that the greatest impediment to an industry standard for after-tax performance reporting is commitment by superannuation funds and investment managers to uniform and consistent disclosure of the data required to calculate meaningful, comparable after-tax returns, given the lack of any regulatory requirement to do so. We believe that the Australian Securities & Investments Commission should require investment managers to publish the necessary information to enable the calculation of aftertax returns on a quarterly basis (or whenever funds distribute in the case of managed funds). Morningstar calculates and publishes after-tax returns for pooled investment vehicles globally, including Australia, and would be willing to work with the Australian Securities & Investments Commission and other bodies to explain our methodology and its benefits Disclosure Are there more efficient ways that super funds could satisfy their various disclosure obligations? Alternatively, could super funds very cheaply and simply exceed those obligations by, for example, placing the fund's trust deed and other material agreements on the fund's website? It is unlikely that the average member would need this information, but transparency and instantaneous access to information has major systemic benefits for analysts, advisers, research houses which would ultimately flow to members. Measures such as publishing trust deeds, offer documents, and related materials on websites are effective and economical ways of increasing transparency and member engagement. On 19 November 2008, the US Securities & Exchange Commission announced that from 1 January 2010 it would require US mutual funds to provide investors with a concise plain English summary of the key information they need to make informed investment decisions, to appear at the front of a fund's prospectus. The SEC also approved amendments to securities legislation to encourage funds to make greater use of the Internet to enable investors to receive more detailed information in a way that best suits their needs. It is, however, our view that the key disclosure issue for superannuation and funds management is the comprehensive, periodic disclosure of portfolio holdings (the stocks, bonds, and other securities which constitute the portfolios of superannuation funds and other pooled investment vehicles). Australia lags global best practice in this area. In a Morningstar study of global fund investor experiences published earlier this year, Australia and New Zealand were the only countries among the 16 assessed which do not require regular, full portfolio holdings disclosure. 5 Morningstar Australasia Pty Ltd 14-Dec-09

6 US mutual funds, for instance, are required to disclose portfolio holdings by filing quarterly reports with the SEC. In these N-Q filings, funds are required to list the securities they hold and the amount. A sample N-Q filing is attached as an appendix to this submission, as are sample Morningstar reports for Australian and US funds showing the kind of information which can be presented as a result of this degree of disclosure. Australian superannuation scheme providers and fund managers currently have a mish-mash of approaches to holdings disclosure. Some disclose information on a monthly basis, some quarterly, and some not at all. Some disclose their top 10 holdings only, and some nothing. Superannuation and managed funds disclosure in Australia is also poor when compared with the extensive mandatory disclosure requirements for listed securities. Periodic disclosure of full portfolio holdings would have a number of benefits. It would enable trustees, investors, and advisers to construct and monitor investment portfolios with increased diversification and which minimise overlap with existing investments. It would also enable better assessment of whether investment managers are staying 'true to label' in terms of market capitalisation and investment style characteristics. The level of illiquid assets in a portfolio would also be more readily observed. Regular, comprehensive holdings disclosure would also provide greater opportunity for detection of undesirable behaviours such as excessive turnover and 'window-dressing' (the practice of turning over a fund's portfolio holdings close to a reporting period, selling poorlyperforming companies and buying strongly-performing ones, to make the fund's performance look better). Fund managers often worry about disclosing their full portfolios because of a phenomenon known as 'frontrunning', whereby market participants use this information to trade in these stocks, potentially affecting their prices. While we acknowledge this concern, we don't believe it's a sufficiently valid argument against an approach to disclosure such as publishing holdings on a quarterly basis with a mandated time-lag. There is also little evidence from other developed markets which require regular portfolio holdings disclosure that frontrunning has been a significant issue. Additionally, there is little uniformity or consistency in other key information such as the identity of the people managing the money. Product disclosure statements for superannuation funds and other pooled investment vehicles should disclose information such as the key individuals responsible for investment management. Greater disclosure would also reduce the costs of producing investment research, and make it easier for research providers to disseminate third-party information and opinions about funds. This would in turn reduce barriers to entry, resulting in increased coverage as well as reducing the need for conflicted business models such as issuer-pays research. We acknowledge that this degree of enhanced disclosure will impose additional costs on superannuation funds and fund managers. But we believe that it will constitute a rationalisation of the existing ad hoc, patchwork landscape whereby an investor's access to this information varies depending on which superannuation fund or fund manager they have selected to manage their money. 6 Morningstar Australasia Pty Ltd 14-Dec-09

7 Ultimately, uniformity and consistency in portfolio holdings disclosure will increase equity between investors and encourage greater engagement with superannuation and pooled investment vehicles more generally. Most importantly, it would create an information platform that would drive the better assessment of superannuation funds by investors Standards for Performance Fees Should there be some form of standards applying to performance fees? Ideas here could include: requiring that they only be chargeable on an after-tax basis; that only appropriate risk-adjusted benchmarks are used (for example, one fund uses the RBA cash rate as a benchmark against which its enhanced cash fund earns a performance fee); that longer horizons are used than is currently the case; and that there be rules about horizontal equity; clawbacks and high watermarks, disclosure and auditing. We believe that there are a number of best practices investment managers should be required to follow when levying a performance fee. If structured appropriately, performance fees can align an investment manager's aim to maximise its revenue and income with the interests of investors in superannuation and other pooled investment vehicles to produce positive long-term growth (particularly in savings to fund retirement income). If structured poorly, however, performance fees can provide investment managers with inappropriate incentives to engage in riskier investment practices which are not in the interests of superannuation and managed fund investors. Firstly, investment managers charging performance fees should be required to levy lower base management fees than the average, avoiding the situation where the investment manager has an increased total fee take as a result of charging a higher-than-average base fee and a performance-based fee as well. Performance fees should also reference a benchmark which best represents the investment manager's investible universe, therefore rewarding a strategy for outperforming its own asset class. In the case of equities assets, this should constitute an equities market hurdle, rather than the cash rate or a nominated annual percentage rate. Failure to select an appropriate rate hurdle may not reward the investment manager for the excess returns it generates. We also view performance fees that reward investment managers even when they subtract value as poor propositions. Performance fees should also incorporate a high watermark or similar mechanism. ('High watermark' refers to a requirement that a performance fee will not kick in until performance has returned to its previous peak and capital losses have been recouped.) This prevents investors from paying performance fees on returns that represent the recovery of past periods of underperformance. A fund manager may sometimes stipulate that the high watermark is to be reset after a certain period, for example two years. We believe this is inappropriate: the fund and its investors may still be suffering overall losses after two years. The best solution is for the fund manager not to charge any performance fee until previous underperformance has been recouped, irrespective of how long that takes. 7 Morningstar Australasia Pty Ltd 14-Dec-09

8 Performance fees should additionally operate according to a symmetrical structure whereby the fee goes up if a fund manager outperforms, but down by an equal proportion when the fund manager underperforms. This 'fulcrum fee' structure rewarding outperformance, but equally also penalising underperformance is currently the standard in countries such as the United States and Norway. Finally, performance fees should be disclosed prominently and clearly and explained in plain language in fund literature. Several scenarios should be provided to help investors understand how the performance fee might apply under a variety of market conditions, and these should include dollar-worked examples as well as examples using percentages. To summarise, trustees of superannuation funds and investors should have confidence that an investment manager charging a performance fee: is measured against an appropriate benchmark representative of the asset class; has a high watermark where the investment manager has to recover previous losses before charging future performance fees; charges a lower base fee, avoiding an increased total fee take; should be structured as a fulcrum fee, rewarding outperformance but also penalising underperformance; and explains the performance fee calculation method clearly and in a prominent position in offer documentation. 8 Morningstar Australasia Pty Ltd 14-Dec-09

9 Classification Policy Australian Investments October 2007

10 Contents Part I Overview 1 Objectives of this document 2 Objectives of the Morningstar Classification System 3 Application of the Classification System 4 Asset Classes and Investment Sectors 5 Definition of Growth Sectors 6 Fund Investment Style and Size 7 Assigning a Fund to a Category 8 Definition of Legal Types for Australia 9 Fund Type 10 Peer Grouping Part II Specific Fund Classification Details 11 Multisector Organisation 12 Definitions of Multisector Categories 13 Definitions of Sector Classifications 14 Style- and Size-based Categories for Equity Funds Page 2 October 2007 Morningstar Australasia Pty Ltd ABN: , AFSL:

11 Part I Overview 1 Objectives of this document The objective of this document is to describe the Morningstar classification system for managed investments and to define the key components of the system. We outline the methodology used to determine the classifications for most managed investments so that everyone can have a clear understanding of the rationale behind the Morningstar fund peer groups. This document has been compiled in conjunction with Morningstar s global offices to meet the requirements of our clients domestically and globally. This relates to a dynamic industry where change is constant. In such an environment it is sometimes necessary for Morningstar to make changes to the classification of certain funds so that they meet the dynamic needs and requirements of advisers and their investors. 2 Objectives of the Morningstar Classification System The objective of the Morningstar classification system is to meet the needs of the majority of our clients by providing groupings of funds which can be reasonably considered to be close investment alternatives and for which performance and other statistics such as fees are comparable. The system has also been constructed to provide investors with a valuable referencing scheme to make fund selection much more efficient. Where possible, these classifications are intended to be compatible with Morningstar s portfolio building philosophy by providing a fundamental structure for effective portfolio diversification across all asset classes. Criteria for determining close investment alternatives include (in order) whether: The tax treatment and legal characteristics of the funds is the same; Benchmarks, stated maximum and minimum exposures to asset classes, and possibly actual total exposures to various sectors, are similar and fall within the Morningstar definitions; The funds could be considered to be alternatives for performance comparisons and other statistical analysis and in constructing an investor s portfolio; The fund s investment style and market capitalisation constituency is considered to be highlyconsistent for portfolio construction purposes; and Any other criteria considered relevant by Morningstar. (For example, statements from the fund manager, where appropriate, may be considered when determining the classification of a fund.) Page 3 October 2007 Morningstar Australasia Pty Ltd ABN: , AFSL:

12 Morningstar s aim is to maintain a classification system which achieves widespread market acceptance in the following areas: performance comparisons within groupings where both volatility and return can be justifiably compared; statistical analysis, including ratings, within groupings can be justifiably compared; easy choice of competing funds and market analysis through a logical referencing scheme; analysis which does not suffer from inconsistency of taxation treatment; and a classification system which is easily-understood, user-friendly, technically-defensible, and implemented without great expense so that classifications can be produced in reasonable timeframes. 3 Application of the Classification System This classification system applies to all publicly-available retail and wholesale funds in the Morningstar database. We include here definitions related to the broad investment universe, offering, fund type, legal types, sectors, investment style, categories, and overall peer groups. We start by defining critical terms including terms related to the assets in which managed investments invest. The Morningstar classification system is flexible and transparent, making peer group comparability more effective for investors, advisers, and institutions. 4 Asset Classes and Investment Sectors Asset classes are the broadest groupings of assets that are defined in a portfolio of managed investments. The next filter we use is sector definitions which relate the assets to a region and/or industry within an asset class. The asset classes and sectors that are used for the purpose of determining Morningstar categories are: Asset Class EQUITY Sector Equity Region Australia Page 4 October 2007 Morningstar Australasia Pty Ltd ABN: , AFSL:

13 BALANCED* Equity World Equity World/Australia Equity Region North America Equity Region Europe Equity Region Asia/Pacific Diversified - w/o Japan Equity Region Japan Emerging Markets Equity Sector Australia - Real Estate Equity Sector Australia - Natural Resources Equity Sector Global - Technology Equity Sector Global - Real Estate Multisector - Conservative Multisector - Moderate Multisector - Balanced Multisector - Growth Multisector - Aggressive FIXED INCOME OTHER** Australian Cash Australian Cash Enhanced Mortgages Mortgages - Aggressive Australian Bonds Global Bonds Global/Australian Bonds Diversified Credit High Yield Multi-Strategy Income Reserve-Backed Alternative - Australia Hedge Funds Alternative - Australia Long/Short Alternative - Australia Agricultural Alternative - Australia Infrastructure Alternative - Australia Private Equity Alternative - Global Hedge Funds Alternative - Global Long/Short Alternative - Global Infrastructure Unlisted and Direct Property - Australia Unlisted and Direct Property - Global Miscellaneous * Balanced does not constitute an asset class by definition, however it is a broad investment class which does form part of the Morningstar categories for Multisector funds. ** Other does not constitute an asset class by definition, however it is a broad investment class which does form part of the Morningstar categories for various investment alternatives. Page 5 October 2007 Morningstar Australasia Pty Ltd ABN: , AFSL:

14 5 Definition of Growth Sectors Asset classes are then subdivided further into growth and income sectors, and then further within these two sectors. Where there are a number of sectors within the fund s investment universe, we may classify the fund as multisector. By defining the portion of growth sectors within a fund, peer groupings for multisector funds can be assigned based on the portion of assets within the growth and non-growth (income) sectors. Growth Sectors Non-growth (Income) Sectors Domestic equities International equities Domestic property International property Domestic cash International cash Domestic bonds International bonds Alternative assets * Assigning alternative assets into a growth sector may be warranted, however this depends largely upon the strategies that are employed by the fund manager. 6 Fund Investment Style and Size Morningstar has introduced a critical element into the fund classification system, an examination of the investment style and market capitalisation composition of a fund. Morningstar s investment style analysis assigns each equity fund into either value, blend, or growth investment style using Morningstar s proprietary 10 factor style methodology to examine the style attributes of each fund. By assigning a fund into a style-based grouping, a more narrowly-defined analysis can be performed. The depth of detail provided by Morningstar s investment style analysis of a fund in this classification structure enables advisers and their investors to diversify their portfolios more effectively. It also makes more effective peer group comparisons possible, given that there is consistency with the underlying style characteristics of a peer grouping, providing more refined comparative statistics. The risk composition of peer groups is narrowed further once the size/market-cap of the underlying securities has been considered in conjunction with the fund s investment style. Equity Fund Style Equity Fund Size Value Large Blend Mid/Small Growth General* General* * General applies to sectors that do not have specific style and size characteristics to differentiate between funds. Not all sectors are classified into specific style and size groupings, particularly since some Page 6 October 2007 Morningstar Australasia Pty Ltd ABN: , AFSL:

15 sectors are already narrowly-defined with regard to their risk profile. In addition to this, the style and size analysis is more prominent with diversified equities funds that have exposure to a number of industries, both domestically and internationally. For this reason, style and size classifications are limited to domestic and international equities funds. 7 Assigning a Fund to a Category A fund category is based on exposure to asset classes, investment sectors, the investment style and market-cap allocation, and the associated risk and return characteristics of funds. These factors are considered when constructing the Morningstar categories so that peer group comparisons can be performed reliably across the whole Morningstar fund universe. In determining a fund s category classification, the fund is first allocated to an asset class, followed by an allocation to a sector. Once they have been determined, the size and style constituency of the fund is considered, with particular regard to equities-based assets, where applicable. The style and size allocation is combined with the asset class and sector to arrive at narrowly-defined classifications of risk exposure. To determine classification in a Morningstar category, the steps taken by Morningstar are as follows: Review the fund s benchmark asset allocation as provided by the fund manager, and interpret the benchmark figures as the exposure to a particular asset class and sector. Equities funds are required to provide a history of the fund s portfolio holdings data so that a fund can be incorporated into Morningstar s 10 factor Style Box methodology. This holdings data must be updated at least quarterly. Once the Morningstar Style Box methodology is applied to a fund s complete portfolio holdings data, the fund style and market capitalisation constituency of a fund can be reliably determined and the appropriate category assigned to the fund. If benchmark and asset allocation range information is not available to Morningstar, the objectives and actual asset allocation history of the fund will be considered. Additionally, if historical fund investment style data is not available, the appropriate categorisation for equitiesbased funds is made in conjunction with Morningstar s qualitative research team. Finally, all available evidence will be reviewed to determine if discretion should be applied in classification. Available here means that the data is already included in the Morningstar database. On an ongoing basis, Morningstar will continue to monitor benchmark and actual asset allocation data, together with fund investment style, to ensure that the fund s original classification remains appropriate. Morningstar may also consult with fund managers on the classification(s) of their fund(s) in situations where there is not obvious clarity. Morningstar reserves the right to make the final decision on classification of any fund under its classification system and to apply its discretion at all times. The application of this discretion will ensure that funds can be compared fairly as stated in the objectives of this document. Where uncertainty or ambiguity exists, Morningstar will undertake the research necessary to ensure appropriate categorisation. Funds that do not fit Page 7 October 2007 Morningstar Australasia Pty Ltd ABN: , AFSL:

16 into a well-populated category will be placed into a Miscellaneous category so that they have at least basic representation on the Morningstar database. Once classified, it is expected that a fund s category will rarely change. Changes will usually only occur because of substantial changes to a fund s strategy or objectives. Numbers of Funds Required to Create a Category Given the diverse range of funds that are available to investors, the number and form of categories which could be created are almost limitless. In the interest of keeping the structure simple and accessible to investors, advisers, and fund managers, Morningstar uses its discretion to construct additional categories, ensuring that categories will be limited to peer groupings that are considered to be reasonably well-populated for any comparative analysis. Where a fund does not fall into a prescribed category, and the creation of a new category is not justified, then a fund may fall into a Miscellaneous category so that it can be included within the classification scheme. Funds that fall into Miscellaneous categories are not considered to be reasonable substitutes for each other, and as such should not form the basis of peer group comparisons. Category Structure Asset Class -----> Sector > Style > Size = Morningstar Category Table of Australian Category List overleaf Page 8 October 2007 Morningstar Australasia Pty Ltd ABN: , AFSL:

17 Australian Category List Equity Region Australia Other Equity Region Australia Large Value Equity Region Australia Large Blend Equity Region Australia Large Growth Equity Region Australia Large Geared* Equity Region Australia Mid/Small Value Equity Region Australia Mid/Small Blend Equity Region Australia Mid/Small Growth Equity World / Australia Equity World Large Value Equity World Large Blend Equity World Large Growth Equity World Mid/Small Value Equity World Mid/Small Blend Equity World Mid/Small Growth Equity World Other Equity Region North America Equity Region Europe Equity Region Asia Pacific w/o Japan Equity Region Japan Equity Sector Australia Real Estate Equity Sector Australia Natural Resources Equity Sector Global Technology Multisector - Conservative Multisector - Moderate Multisector - Balanced Multisector - Growth Multisector - Aggressive World/Australian Bonds Reserve Backed Specialty Australian Bonds Cash Specialty Australian Bonds Cash Enhanced Australian Bonds Diversified Mortgages Specialty Australian Bonds High Yield Global Bond Diversified Hybrid Income Alternative Australia Hedge Funds Alternative Australia Long/Short Alternative Australia Agricultural Alternative Australia Private Equity Alternative Global Hedge Funds Alternative Global Long/Short Unlisted and Direct Property Australia Unlisted and Direct Property Global Miscellaneous Equity Sector Global Real Estate Page 9 October 2007 Morningstar Australasia Pty Ltd ABN: , AFSL:

18 8 Definition of Legal Types for Australia Legal type is used as another tier in grouping managed funds in the peer group system. A separate legal type is created for funds which differ in terms of legal status and taxation treatment. The purpose of defining legal type is to enable reporting by legal type where required by clients. There may not be a direct relationship between legal type and category, because we may combine more than one legal type in a particular category. Australian Legal Types Legal Type Name Legal Structures Description of Legal Structure Taxation Structure Included Unit Trusts (Investment Trusts) Unit Trusts Unit Trust Distribute all income, therefore fund not taxed Investment Bonds Insurance Bonds Insurance Policy Assessable fund income taxed at maximum of 30% Superannuation Funds Superannuation Funds Superannuation Entity Assessable fund income taxed at 15% Allocated Pensions Allocated Pensions Superannuation Income Stream Income generated from segregated pension assets is free of income tax at the fund level Allocated Annuities Allocated Annuities Insurance Policy Income Stream Income generated from segregated pension assets is free of income tax at the fund level Immediate Annuities Immediate Annuities Insurance Policy Income Stream Income generated from segregated pension assets is free of income tax Term Allocated Pension Allocated Pensions Superannuation Market-Linked Income Stream Income generated from segregated pension assets is free of income tax Term Allocated Annuity Allocated Annuities Insurance Policy Market-Linked Income Stream Income generated from segregated pension assets is free of income tax Page 10 October 2007 Morningstar Australasia Pty Ltd ABN: , AFSL:

19 9 Fund Type At this level of the categorisation exercise the focus is still on the different administrative and fund features that are offered to investors. It is important to segregate different fund structures further so that greater differentiation between funds is possible. Retail High-volume, low-value transactions, these funds are targeted toward many investors who are not deemed to be sophisticated in the legal sense of the term. Due to the nature of the fund structure there are many associated fees, with noticeably higher ongoing management fees. These funds will generally have the following characteristics: Low minimum investment - generally less than $50,000; Low minimum additional investment - generally less than $50,000; Higher up-front and ongoing fees; and Service tailored to general public. Wholesale Wholesale funds are generally aimed toward and offered to the professional/sophisticated investor markets, and therefore a high minimum investment will generally apply to such funds (most commonly above $50,000). Fund transactions are generally less frequent and on a much larger scale, resulting in lower associated fees and different fee structures. The administrative and reporting requirements of wholesale funds are also streamlined, therefore lowering further the associated fees for funds which have correspondingly high-volume, low-cost structures. These funds will generally have the following characteristics: Higher minimum investment - generally greater than or equal to $50,000; Higher minimum additional investment - generally greater than or equal to $50,000; Lower up-front and ongoing fees; Service tailored to investor with higher demands; and Accessible only through other entities, for example superannuation funds and IDPS providers. By creating peer groups within retail or wholesale classifications, greater comparability is realised, given the significant difference in the ongoing fees charged by the two structures and enabling more efficient referencing. Page 11 October 2007 Morningstar Australasia Pty Ltd ABN: , AFSL:

20 10 Peer Grouping So far we have detailed the need to assign funds into categories, legal types, and fund types to create fund peer groups for referencing purposes, and to enable consistent fund comparability within narrowly-defined groupings. Peer Group Structure Morningstar Category > Legal Type > Fund Type = Peer Grouping When the category, legal type, and fund type are considered for each fund, a refined peer group is created. All variables are considered when making peer group comparisons. A fund peer group is a group of funds with the following characteristics: Taxation treatment of funds within the peer group is the same; Benchmarks, stated maximum and minimum asset exposures, objectives or possibly actual asset exposures for funds within the peer grouping are comparable; The style and size constituency of the fund is reliably consistent; The funds could be considered to be alternatives from which to choose in constructing a client s portfolio; Performance data (both volatility and return) can be justifiably compared; and Other statistics such as ratings can be justifiably compared. This peer group structure applies, in particular, to open-end unlisted managed investments on the Morningstar database. Page 12 October 2007 Morningstar Australasia Pty Ltd ABN: , AFSL:

21 Part II Specific Fund Classification Details 11 Multisector Organisation A fund belongs to a multisector category if the fund has exposure to an income or growth sector and at least one other growth sector, except where cash is involved. Where cash exposure is greater than 30.0 percent and the fund is exposed to one growth sector, then a multisector categorisation would be warranted. This definition is, like all other classification exercises, subject to the application of discretion by Morningstar. There are a number of exceptions to classification of funds with one growth asset class and domestic cash as multisector, as follows: Where there is exposure to equities (international and/or domestic) and domestic cash and the total exposure to equities exceeds 70.0 percent, then the fund will usually be classified into an Equity World / Australia category. (For example, 40.0 percent exposure to Australian resource shares and 50.0 percent exposure to international resource shares with the remainder in cash. This fund is classified into an Equity World / Australia Category (provided there are sufficient similar funds for the category to exist), not multisector, although the fund is exposed to two sectors apart from domestic cash.) Note: where the exposure to Australian equities includes listed property trusts, then as long as this does not constitute an intended property exposure by the manager over and above the index allocation to this sector, the fund will be classified into an Equity World / Australia Category. However, if the listed property trust component is sufficiently greater than the listed property trust component representation in the benchmark index, the manager is considered to have intended the portfolio to have a property exposure in its own right. In these instances, the fund will be classified into a multisector category. Morningstar has created a separate category for international and Australian fixed interest, called the World/Australian Bonds Category, given that there are a sufficient number of such funds with more than one sector exposure apart from Australian cash and sufficiently high exposure to these two sectors. Managed investments engaging in direct property investment may have high cash levels and substantial exposure to listed property trusts. These funds are also treated as an exception to the rule that funds with exposure to two sectors apart from cash are multisector, as direct and listed property fall into two different sectors. A fund with investments in both listed property trusts and direct (unlisted) property (and possibly cash) only will be classified into an unlisted property category if the combined property exposure exceeds 60.0 percent of the fund s portfolio, and the direct property exposure exceeds 20.0 percent. If the direct property exposure is less than 10.0 percent, or there is a demonstrated intention to reduce direct property to a very low level, then discretion may be exercised, and the direct property exposure ignored in classifying a fund. This may mean that a fund with a low and declining level of direct property exposure and the remainder of its exposure to listed property and cash will be allocated to an Equity Sector Australia Real Estate Category, if the total property exceeds 60.0 percent. Morningstar discretion will also be applied in the situation where funds which include low domestic fixed interest exposure may also be included in property categories. Page 13 October 2007 Morningstar Australasia Pty Ltd ABN: , AFSL:

22 Where a fund has 80.0 percent or more cash and up to 20.0 percent in one other sector, the fund should be classified as enhanced cash. Where there is an unusual combination of assets within the growth or non-growth assets, Morningstar may use its discretion to classify such a fund to a more appropriate category. Tests to Determine if a Fund Should be Within a Multisector Category The tests to determine if a fund should be in a multisector category (with examples) are as follows (assuming the fund is not reserve-backed): 1 How many sectors is the fund exposed to apart from domestic cash? If the answer is two or more, the fund is classified as multisector, unless it is only exposed to listed and direct property and cash. If total property exposure exceeds 60.0 percent and there is no other exposure except possibly cash, the fund will not be classified multisector. Proceed to the next test if the fund has fewer than two asset classes apart from domestic cash. 2 What is the number of sectors to which the product is exposed apart from domestic cash? If the answer is two or more, the product is classified as multisector with some exceptions. If there are only two sectors apart from cash, the product is multisector provided the sectors are not within the same asset class and account for over 70.0 percent of the asset allocation, or there is over 60.0 percent exposure to property (either listed or direct) apart from cash. Proceed to the next test if the fund has fewer than two asset classes apart from domestic cash. 3 Is the fund exposed to only one growth sector, and is the only other sector domestic cash, which makes up 30.0 percent or more of the portfolio? If the answers are yes to both of these questions above, then the fund is classified as multisector, unless the single growth sector is direct property. (Proceed to the next test if there is only property and cash exposure.) If the fund is exposed to only one growth sector and Australian cash, and the cash exposure is less than 30.0 percent, then the fund is most likely to be classified into a sector-specialist category corresponding to the non-cash exposure. 4 Is the fund exposed to only cash and property, and does the property exposure exceed 60.0 percent of the portfolio? If the answers are yes to both of these questions, then the fund is not classified multisector, but will be classified into a property category. The fund may also be classified into a property category if its exposure includes a small amount of fixed interest in the portfolio (in addition to meeting the above conditions). Page 14 October 2007 Morningstar Australasia Pty Ltd ABN: , AFSL:

23 12 Definitions of Multisector Categories for Australia There are a number of multisector categories which are defined as follows: Multisector Conservative Categories for multisector funds with exposure of up to and including 20.0 percent in growth sectors. Multisector Moderate Categories for multisector funds with exposure over 20.0 percent and up to and including 40.0 percent in growth sectors. Multisector Balanced Categories for multisector funds with exposure over 40.0 percent and up to and including 60.0 percent of their assets in growth sectors. Multisector Growth Categories for multisector funds with exposure of over 60.0 percent and up to and including 80.0 percent of their assets in growth sectors (but if there are insufficient funds to create an Aggressive category then the definition of the Growth category is over 60.0 percent in growth sectors). Multisector Aggressive Categories for multisector funds with exposure of over 80.0 percent of their assets in growth sectors. 13 Definitions of Sector Classifications Generally, a fund is classified into a single sector-based category (provided the fund is not reserve-backed) in the following circumstances: 1. The fund is exposed to only one sector and domestic cash, and its exposure to the non-cash sector exceeds 70.0 percent. 2. It is exposed to over 60.0 percent property (listed and/or direct) and infrastructure debt or equity and with the remaining exposure only in domestic cash. (Usually such funds will be classified into a sector category - either the unlisted property or Australian equity property categories.) A major exception to the above is Australian cash categories (other than Enhanced Cash categories), where there cannot be any exposure to any other asset class. (Exposure to cashequivalent derivatives is acceptable in cash categories.) If a fund is exposed to over 80.0 percent Australian cash, then the fund is classified as enhanced cash as follows: Page 15 October 2007 Morningstar Australasia Pty Ltd ABN: , AFSL:

24 a) If the non-cash component is a growth sector. (For example, a fund with 81.0 percent Australian cash and 19.0 percent international equities will be classified into an enhanced cash category.) b) If the non-cash component is not a growth sector. (For example, a fund with 81.0 percent Australian cash and 19.0 percent international fixed interest will be classified into an enhanced cash category). For example, the following funds would be classified as sector funds: 90.0 percent Australian equities and 10.0 percent Australian cash is classified in an equities sector category percent domestic equities is classified in a domestic equity category percent fixed interest and 50.0 percent Australian cash is classified in a fixed interest category percent fixed interest and 81.0 percent Australian cash is classified in an enhanced cash category. There are numerous scenarios where a fund s exposure to cash and other growth and nongrowth sectors may vary to some degree. It is necessary to create a manageable set of standard groupings of funds for assignment to particular sectors where the risk parameters ensure a reasonably well-populated peer group. Separate and highly-specialised categories will not be created unless there are sufficient like funds to justify the creation of a new peer group. 14 Style- and Size-based Categories for Equities Funds Fund investment styles are determined for equities funds on the Morningstar database to facilitate more detailed categorisation of the fund universe, and to allow better peer comparisons. Morningstar generates fund style information on an array of equities funds so that advisers and investors are aware of the attributes of the underlying securities that make up the portfolio in a fund, therefore providing insight into the risk composition, security overlap, and market coverage of the funds in a portfolio, and helping ensure appropriate portfolio diversification. Each equities category will have an assignment to a value, blend, or growth fund universe, except for the following circumstances: The equities funds are region-specific, in the sense that the portfolio is comprised of a narrowly-defined set of securities that are derived from a specific region or country; The equities funds are sector- or industry-specific, meaning that the equities funds invest into securities that are restricted to a certain industry or sector within the broader economy; The equities funds use a significant amount of derivative instruments in the portfolio; and The portfolio is geared by a substantial amount. Should a fund fall outside these exceptions, it will be allocated into one of the appropriate stylebased groupings prescribed by the Morningstar 10-factor Style Box Methodology. The Style Box methodology is constructed around the market capitalisation break points that are considered for each portfolio, enabling the style analysis to take place within an applicable grouping of securities that share the same size characteristics. The Style Box methodology also enables Morningstar to produce aggregate figures of the size composition of the underlying securities Page 16 October 2007 Morningstar Australasia Pty Ltd ABN: , AFSL: