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By Salman Ahmed, CFA and Ashley Redmond | 10-29-2012

Interpreting analyst reports

What star rating, analyst rating and stewardship grades mean for your portfolio.

Ashley Redmond: We've been getting a lot of questions lately regarding interpreting an analyst report and then proceeding to properly apply it to your own research. So, I have Salman here with me, and he is going to explain what to look for in a report and how it applies to you.

Thanks for joining me Salman.

Salman Ahmed: Thanks for having me.

Redmond: So, I have pulled up Mawer Canadian Equity as an example, and you actually wrote that report.

Ahmed: That's right.

Redmond: So, what I wanted to do was start with Morningstar's five P's – that's the criteria that the fund analysts use. So, why don't you tell me about those?

Ahmed: Sure. So, the five P's or what we call the five pillars – and like you said this is where we focus our research when we're doing our analysis. So, the five P's include, parent, people, process, performance and price and these together make up the five P's.

Redmond: Okay, great. So, why don't we start with the people section? Now, does that just cover the managers?

Ahmed: Well, the managers are definitely a very important part of the analysis, but we also go beyond just the managers. We want to understand as much as we can about the entire decision-making process and every aspect of how that decision gets made. So, we'll talk to the associate or assistant portfolio managers as well. We'll try to speak to the equity analyst or fixed income analyst or the risk team. Whatever team supports the portfolio manager's decision-making, we will try to have a chat with them and try to discuss the process and try to understand if there is any advantage that people have over their peers.

Redmond: Okay, great and then we have the parent section.

Ahmed: That's right. And for the parent section, we've drawn on our stewardship analysis. In this, we're judging if a fund sponsor policies help align portfolio managers with unitholders. So, we'll look at things such as the personnel turnover the firms have faced, the overall transparency, and the kinds of fund launches the firm does. Are they flavor of the month? Or are they consistent with the firm's expertise? We also look at how the portfolio managers are incentivized to see if there is alignment between the incentives and the unitholder experience.

Redmond: Okay. Great and then we have two for process; we have the process investment approach and process portfolio positioning.

Ahmed: That's right. So, in these sections, we look at the advantage the investment process may have over other funds in the category. We analyze things such as the idea generation, portfolio construction, and risk management amongst others. We want to see if the process is consistent with the objective of the fund, a process may be perfectly sound, but if it's a small cap fund and the process has a bias towards large cap stocks then we'd be negative on that process and the portfolio positioning looks at how that process is being applied to the fund right now, so in the present. So, is it consistent with the overall process? What kind of sector weights? What kind of position? What kind of risk exposures does the fund have? And is that consistent with what the stated objective and the investment process are.

Redmond: Okay. Great and then we have performance. Now, for performance, what are your guidelines? So, for example, since a fund with an inception date of 20 years or more is rare, are you stuck with only looking at the three-, five- and 10-year returns?

Ahmed: Well, we are not just looking at returns since inception. We want to know how the current manager has performed. So, we're looking at the performance of the manager's tenure on that fund and we're not just looking at absolute returns. We want to see the risk-adjusted returns. So, to understand the kind of ride investors have experienced on the fund and the kind of ride they may experience going forward.

Performance isn't just returns though – it's correlations, it’s sharpe ratios, tracking error, drawdowns, capture ratios, et cetera. There are also managers that have only been on the fund for a short period of time and for those managers, we look at other funds that they have been on either as a lead, associate or assistant – to get some indication of the track record they've build up during their time managing the funds.

Redmond: Next up we have the price action and I assuming it is a deeper analysis than just MER.

Ahmed: Yes, it is a deeper analysis. So, we are looking at how the MER ranks relative to its category in its distribution channel. So, a positive score in the price section implies that the fund ranks amongst the top quartile of funds in its distribution channel and in its specific category and negative would be the most expensive quartile. And we are not just looking MER. We are also looking at the trading expense ratio as well. That’s also a cost that’s borne by the unitholders. So, if the fees are – if there is a new manager on the fund and he has indicated or she has indicated that the portfolio may increase higher portfolio turnover, we try to make investors aware that this may cause an increase in the trading expenses that the fund incurs.

Another thing we are looking at is the trend of the fees. So, we like to see fees come down as the asset level increases of a fund and we pay particular attention to fee increases, if – that are correlated with increase in asset, that usually raises a red flag for us.

Redmond: I am assuming that the Morningstar opinion section, which is usually found near the top of the report, just summarizes the five P's that we discussed?

Ahmed: Yes and no. The opinion section is intended to explain the thesis behind our Morningstar analyst rating. It’s a given message, a clear indication of why the rating is what it is. We encourage our readers to examine the entire report rather than just specific sections, so that they fully understand how we came about our opinion.

The analyst ratings range from gold, silver, bronze, neutral to negative. Of the three medals, gold, silver, and bronze are an indication that the analysts believe that this fund has some advantage that will cause it to consistently outperform its peers over a full market cycle. And the difference between the gold, silver and bronze is our level of conviction in that manager, so a gold analyst-rated fund would imply that we believe that this fund has the highest level of conviction in the manger's ability to outperform.

Neutral rating is quite self-explanatory I think. It just means that the fund is going to not necessarily outperform or underperform its peers, but a negative rating implies that we believe there is something fundamentally wrong with the fund that will cause it to underperform its peers.

Redmond: Last but not least, we have the star rating, which is always located at the top of the page right beside the name of the fund.

Ahmed: That's right. While the analyst rating is a forward-looking assessment, the star rating is a backward looking assessment. It’s also a measure of risk-adjusted returns, and it's comparing the risk-adjusted returns relative to its peers in a specific category. And think of it like a report card. I think that’s a good way to understand what the star ratings purpose is.

When making investment decision, we always encourage investors not to look at each one of these tools – star rating, analyst rating or stewardship grades in isolation – but they should be used together to make whatever investment choices investors are looking to make.

Redmond: Thanks so much for taking the time today, Salman. I know investors will appreciate it.

Ahmed: Anytime.