Presenter: And Paul, you've been quite vocal on the inadequacies of the SRRI calculation.

Transcription

1 Morningstar - KIID Key Investor Information Document - KIID Paul Kaplan, Jeff Strazis & Neil Simmonds Presenter: I'm joined now by Neil Simmonds, Partner at Simmons & Simmons, Dr Paul Kaplan, Director of Quantitative Research, and Jeff Strazis, Director of Global Product Strategy, Adviser Software, from Morningstar, to discuss the key challenges and implementation of the Key Investor Information Document, or KIID. Morningstar and Simmons & Simmons have partnered together to create a one-stop offering to meet the needs of asset managers by bringing their extensive legal and technological expertise together. Neil, what are the key challenges facing asset managers with regard to the KIID? Neil: There are many. The first one I'd mention is the obvious one. It's the requirement to reduce the key messages about the fund into two sides of A4. That's quite a challenge. Beyond that, the sheer volume of the documents that many managers with any scale are going to have to deal with and to deliver these documents on time, and the next thing is, really, to continually monitor them. It's not just a static document; it has to be continually monitored, particularly as regards the SRRI, which I'm sure we'll come on to, the Risk Indicator, and that is something that managers maybe haven't quite focused so much on. For us, it's a legal document but it has very significant technological aspects to it and that's why we think it makes so much sense for us to be joined up with Morningstar on this project. Presenter: And Paul, you've been quite vocal on the inadequacies of the SRRI calculation. Paul: Yes. Presenter: How is that likely to fail investors? Paul: Well, let's start with the name, Synthetic Risk Reward Indicator, a very unfortunate choice of name because, in fact, it has nothing to do with reward. It's a measure of risk. It's a volatility standard deviation. The choice of name might be due to a misunderstanding of modern portfolio theory which says there is a trade-off between risk and reward but only among well-diversified portfolios, and there really is no relation between risk and reward for any given security such as a single asset class fund, as most funds are. Presenter: And how does the SRRI help investors with building risk-appropriate portfolios? Paul: Well, unfortunately, it's a very limited value in there, again because modern portfolio theory teaches us to combine securities or funds or asset classes that move

2 differently. When one zigs, the other should zag. Now, so we can have two asset classes, for example, we might have an equity fund on the one hand and we might have a leveraged fixed income fund on the other, both of which are going to score the same in the SRRI calculation because they have the same volatility; yet, in combination, they could actually reduce the investor's risk and I think that's the most important thing that's missing from the SRRI calculation as a risk indicator. Presenter: And Jeff, I'll bring you in there, what are Morningstar's plans with the SRRI calculation? How do you see it evolving? Jeff: Well, we have a couple of initiatives. The first is to create a whole-of-market implementation of the SRRI based on Morningstar's interpretation of the directive, the methodology, and this would provide a consistent implementation because there is some room in the methodology for judgement that might lead to one manager calculating a SRRI in a way that's somewhat different from a very similar fund from another manager. So we feel that this Morningstar version of the SRRI would provide an apples to apples comparison across the entire UCITS universe here in UK and around Europe. So that's the first initiative. We also are doing bespoke calculations for some of our clients where we're building an algorithm that would allow them to specify some of these judgemental things like which fund type the fund is in, as my fund type, and for track record extensions, which benchmarks are proxies to use, so a couple of things there. You know, I've been working with Paul quite a bit on our methodology and our development of the Morningstar version and, you know, agree with a lot of his comments about some of the limitations there. In the future, we hope that through our research and analysis and the capabilities we have as an organisation that we might build influence, ESMA and some of the other involved parties about how we might as an industry look to improve this measure that would help investors. I think it's a good start for fund selection in isolation, although as Paul's mentioned a couple of times to me risk is kind of multi-dimensional so it's very difficult to boil it down to one little number. But it really fails investors when it comes to portfolio construction which is probably the more difficult part of the task that they face right now. Presenter: Great. And, Paul, what alternative risk measures or changes to the SRRI methodology would you like to see implemented? Paul: Well, for one thing, what I would like to see is risk be brought in in a more multi-dimensional fashion. I think there's real danger in trying to take a very complicated concept such as risk and reduce it down to a single number between one and seven because that could be very misleading, as I mentioned earlier. For example, it doesn't tell you the differences of the sources of risk, for example, equity funds are exposed to equity markets, fixed income to interest rate risk and, you know, these are different sources of risk. And so I think I would want to, first of all, supplement it with other information such as what asset class the fund is in or multiple asset classes if it's in multiple asset classes. I think that's the first place, would be to bring out some of these other dimensions, bring out how useful it might be in a portfolio; it can help you diversify. And then there are

3 other refinements that could be made as well, just in terms of measuring risk. But the SRRI calculation is based on standard deviation which only measures how volatile the portfolio is; it doesn't really tell you sort of like, you know, things like if the market were to crash, how might this fund do, and I think those types of tail-risk measures, I think, would be a good enhancement. Presenter: Neil, can you explain the challenges of delivering clear, plain language in multiple translations? Neil: Yes. I mean, as lawyers, that's one of the main areas of the KIID that we've been working on and is what we, again as lawyers, pride ourselves on is the clear, concise use of language for communication of key messages, and the KIID requires that. I mean this is, as the guidelines require, the use of plain language and are very prescriptive about the way you approach the description of investment objective and policy, for example, and the risk factors. These documents are intended for retail investors. Even if a manager, however, is only selling to institutional investors, there's no exemptions and they have to treat the document as if it were to be delivered to a retail investor. A motivated retail investor, perhaps, but one, the process is about boiling down the essential elements of a fund which may be quite complex into its component parts, and it's not just its component parts in the way that you describe all the things a fund may do; what you really have to do is focus on what the fund actually does, what exposure it's giving to the client and what potentials for returns. As regards translation, clearly, it has to be not just in plain English but it has to be in plain language, whatever the language, and this is where skilled translators come in and, clearly, the use of translation software tools like Translation Memory and also glossaries will be helpful, plain language glossaries, which will develop over time and we're working with translators on the development of those right now. Presenter: And what are the legal aspects involved in the production of the KIID? Neil: Clearly, the KIID is a pre-contractual document. It will be delivered and has to be delivered before sale and in good time, is the phrase, prior to the sale of the contract. So a lot of thought will need to go into the construction of the document, the drafting of the clear, concise messages we've talked about. And there's liability attached, the potential for liability, at least. If it's, amongst other things, inconsistent with the full prospectus, so there is, clearly, a concern for managers there that they have a 60, 100-page full prospectus, some or all of which they think is important and delivers important messages about the product which has to be boiled down effectively into two sides of A4. So the potential for liability is very real. Presenter: Jeff, can you walk us through how Morningstar produces the KIID document? Jeff: Sure. Morningstar is, to a large extent, a data and technology provider. We do other things but as it relates to the KIID production this is kind of where our strength is. What we have is a custom software platform that builds bespoke reports of really any type, fact sheets or the KIID document as well. The first thing that I think needs to be

4 considered is, unlike the prospectus which is a document that is created and kind of maybe needs to be updated from time to time but is a fairly static document, the KIID document has to be monitored and maintained on an ongoing basis. So you have to have this in place. The other piece of it is that depending on how the fund manager implements the KIID documents, the number of documents can escalate quite rapidly. For instance, if you had a fund manager with 10 funds that had maybe three share classes and is distributed into, you know, five countries or five different languages and maybe there's one or two updates to each document a year, the math kind of grows exponentially so ten times three is 30 times, five is 150 times, two is 300, so from 10 funds, you get to 300 documents in a pretty quick fashion. So that, in itself, is an issue. And then if you factor in the requirement that all of these KIID documents are updated within the first 35 days of the business year, the load on these systems, this IT infrastructure, could be tremendous and somewhat debilitating, and when you look at the coordination that needs to take place between groups within the fund company, like the Performance group or the Legal Compliance group, you know, coordination with the advisers like Simmons & Simmons, on the legal side, the translation piece of it, you could see that there's this huge peak demand that will take place in January of every year and this is going to put a huge strain on every factor of the production process. So the infrastructure from a production standpoint is absolutely critical. Presenter: So what about the legal aspects of the distribution of the KIID? Neil: Yeah, a lot of attention has been focused on that recently. It really depends on who is doing the selling and who takes responsibility for the sales process. The rules basically divide the world into two, those distributors for whom the management company or the UCITS take responsibility, and with those distributors the obligation is for the management company to deliver the KIID themselves and to ensure that the distributor they use and for whom they take responsibility delivers them. So they can't effectively get off the hook for ensuring delivery. The other aspect of distribution is distributors for whom the management company takes no responsibility so I'm thinking platforms, other wrap providers, and even IFAs, where there is a clear nexus between that distributor and the investor but not between the management company of the UCITS and the investor. So in that situation, the management company merely has to provide the KIID to the distributor and then the distributor itself has the obligation to pass it on to the investor. Presenter: Jeff, how do you plan on distributing KIIDs across the EU? Jeff: Well, it begins with our data collection operation and our IT infrastructure which is a global high availability, highly scaleable infrastructure. So we have a data collection operation in each of the countries that we operate in here in Europe and it would be the primary responsibility of that team as well as with our team in China to collect these documents and put them into our database and our database then would be available to all of our products, our websites, Morningstar Direct, through our web tools as well. So we would collect the documents that way and distribute them into the products and then we're also offering a distribution or dissemination service to both the asset managers so

5 that they can see that the documents are distributed in a timely fashion to all of their distribution partners and then on the other side we would work with the fund platforms or the distribution partners to be able to collect and deliver all the documents from the different asset management firms that they're working with. So it's a system we have in place right now. We have hundreds of thousands of documents from prospectus to reports. Collecting and adding the KIID into it will be challenging, again for this peak demand, peak publication period, but we're also working with a small group of other data service providers like Morningstar to kind of coordinate the exchange of these files, adding metadata to the PDFs so that they can be read and entered into a database in a very efficient, quick fashion. So we feel that with our global infrastructure and our presence in all these local markets, that we have a very compelling document repository solution for the industry. Presenter: And so how will you keep clients' documents up-to-date and in a timely and compliant fashion? Jeff: Yeah, this is one of the big challenges. So this is kind of more from a production standpoint when we are the partner of the vendor working with the fund company to actually produce the documents. So our system is built with dashboards that map the workflow so that it's easy enough to see where in the process that particular document is or fund document, whether it's, you know, needing data approval or needing translation or needing final review and sign-off, so we can kind of walk our clients through the production process via this dashboard. We also have implemented some monitoring and alerting systems for some of the quantitative aspects of it. Like we talked a bit about the SRRI that needs to be monitored on a weekly basis and the KIID might need to be updated if this SRRI changes, so we'll be monitoring that through our own calculation and then alerting our clients to the fact that they need to at least review and maybe reissue the KIID document. And so the same with some of the other quantitative measures like the ongoing charges and things of that nature so there's a lot of focus on emphasis that needs to be placed on kind of the workflow and the intelligence about where in the process the manager is in producing these documents. We've mapped all that out and we'll be able to walk them through it. Presenter: Gentlemen, thank you very much indeed. Important Information The information, data and opinions expressed ("Information") and contained herein: (1) are proprietary to Morningstar and/or its content providers and are not intended to represent investment advice or recommendation to buy or sell any security; (2) may not be copied or distributed without express license to do so; and (3) are not warranted to be accurate, complete or timely. Morningstar reserve its rights to charge for access to these Ratings and/or Rating report. Neither Morningstar nor

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