Morningstar/OBSR Qualitative Research: One Year On

Dan LefkovitzDirector of Business & Operations, Pan European Research Team, Morningstar Europe

Christopher Traulsen, CFADirector of Fund Research, Europe and AsiaMorningstar Europe

Richard Romer-LeeResearch Director OBSR, a Morningstar company

Qualitative Fund Analysis at Morningstar: Established 1986

Underlying Principles

No charge to issuer

Positive & negative opinions

Investor driven coverage

Qualitative Fund Analysis at Morningstar: Independent since 1986

Principles

► No charge for issuing analysis/rating

► Positive

& negative assessments

► Coverage driven by serving investors

► Global knowledge; local expertise

×

Report for transparency & education

Morningstar + OBSR = Better Together

In-depth. Informed. Independent.

New Morningstar®

Fund Research Report4-page report with data updated monthly

Transparency: Clear reasons given for rating

Elevate the debate beyond good fund/bad fund—educate investors:

What kind of fund is it?What are its portfolio biases?How can investors expect it to behave in different conditions?When is underperformance worrisome?What role can it play?

Global Research at Morningstar 200+ researchers worldwide

Quantitative methodologies team (PhDs, CFAs, MBAs)

100 equity analysts, 2,000 stocks

10 ETF & Closed End Fund Analysts

New: Credit analysis & ratings

80 fund analysts; 4,000+ funds

US: 30 fund analysts

China: 6 analysts

Australia: 10 analysts

Canada: 7 analysts

Europe & Asia: 25+ analysts

OBSR: 14 investment professionals

Morningstar Global Offices

BangkokHong KongSeoulShenzhenSingaporeTaipeiTokyo

MumbaiNew DelhiCape Town

Auckland Sydney

Melbourne

AmsterdamCopenhagenFrankfurtLondonMadridMilanMunichOsloParisStockholmZurich

ChicagoToronto

Pan European & Asian Research Team

×25+ fund analysts located across Europe (+ Hong Kong)×

London, Paris, Munich, Milan, Amsterdam, Madrid, etc.

×Local expertise, local languages, Pan-European perspective

×Senior Team: 6 members; 10 years average experience

×Global Analyst Network

Coverage through 7 May 2010

Elite 78Superior 396Standard 436Inferior 79Impaired 2 Not Ratable 1Under Review 17

1,009 Funds Rated (463 Available for Sale UK)

104 Categories

Funds rated from 125+ Fund Houses based in 10 markets

Aberdeen, Allianz, AXA, Bestinver, BlackRock, Carmignac, Cazenove, Comgest, DJE, DnB

NOR, DWS, Eurizon, F&C, Fidelity, First State,

Franklin Templeton, Generali, Goldman Sachs, Holberg, HSBC, ING, Invesco, Investec, JOHCM, Kempen, KLP, Legg Mason, LODH, Lupus Alpha, MainFirst, Martin Currie, Metropole, Montanaro, Nordea, Odin, Optimix, Petercam, Pictet, Pioneer, Rensburg, Robeco, SAM, Santander, Schroder, Skagen, Sparinvest, Standard Life, Storebrand, Thames River, Threadneedle, Triodos, Tweedy Browne, UBS, Veritas.

Added Value of Qualitative Research

Elite rated with 2 Stars: 3

Superior rated with 1 Star: 6

Superior with 2 Star: 27

Inferior with 4 Star: 7

Inferior with 5 Star: 3

Standard with 4 Star: 111

Standard with 5 Star: 44

Example: Fidelity Global Special Situations

1 Star Fund

Visibility & Commercial Impact

× 1,400,000,000+ downloads• Through Morningstar Adviser Workstation, Direct, websites,

as well as external platforms

×

Private bank in Europe licensing reports on 160 funds for internal

research & to display to bankers & clients

×

Electronic Platforms: e.g. Fidelity Funds Network UK, Comdirect

Germany

× Media• Qualitative Ratings in tables: Investment Adviser, Investment

Week, Portfolio Adviser, International Adviser• Regular Quotes: Financial Adviser, Portfolio Adviser, Financial

News, Investment Week

Qualitative Fund Analysis Philosophy

Our fund analysis is bottom-up and driven by “fundamentals”

There are many tools & datapoints to review risk/reward profile, BUT

Backward-lookingCan lead you to miss key risks or to ignore great funds

Willing to be contrarian—a fund does not have to be performing well for us to like it. Examples:

Fortis Obam, Fidelity Global Special Sits

Five Qualitative Research Pillars

People

Process

Parent

Performance

Price

Fund Review/Assessment Process

Systematic Assessment of 5 Pillars

Ratings Committee: Robust Peer Review Process

Fund company does not review research report before we publish

Fund Review/Assessment Process

Sources of information:Morningstar holdings and performance analytics

Fund annual reports, prospectuses

Global Analyst Consultation

Fund Company Questionnaire

Interviews with Fund Manager and Key Executives

Pillar One: People

Manager experience: viewed qualitativelyhas manager seen a full market cycle?how relevant is past experience?

Team support: does research structure dovetail with strategy and portfolio?

Self-knowledge: does manager understand pitfalls of process, limitations of research?

Incentive structure: how is the manager compensated?

Pillar One: People –

Case Study

Manager of a UK Equity fund has 22 years of experience, is head of equity research at the fund house. Most of that came at the manager’s present firm.

There is no dedicated analyst support, but she focuses on UK large-caps, so the research is doable. She can also draw on work of other equity managers, each of whom has sector research responsibilities.

She is responsible for covering financials and health-care stocks for the house in addition to running the fund and fulfilling her head-of-equities responsibilities.

Her past experience includes macro work - this where we believe she can add the most value.

Pillar One: People –

Case Study

But…Fund is highly constrained in its ability to make sector betsStock selection has been notably poor, especially in financials,accounting for bulk of fund’s underperformance

Pillar One: People –

Case Study

Conclusion: People rating is poorThe manager’s experience is extensive, but we think her skill-set is a poor match for the fund she is being asked to run.

Moreover, stock selection is subtracting the most value in the manager’s areas of specialty.

Given the narrowness of the investable universe, we would not normally be too concerned about a lack of analyst support, but her lack of ability makes this a strong negative.

Pillar Two: Process

Sensible strategy that reflects investment philosophy

Style: e.g. deep value, aggressive growth

Consistent application (stock analysis as aid)

How active is it?

Assess risks on fundamental basisLarge position sizesSector / geographic concentrationValuationCredit quality & durationAsset bloat

Pillar Two: Process -

Case Study First State Global Emerging Markets

Universe is large which is of concern. It is also one fraught with risk.

Team focuses on rigorous bottom-up analysis, and professes to have a quality bias and a long-term orientation. Difficult to do with a large universe where information can be scarce.

But staff and process are well matched to strategy:Use a quant screen to bring down the universe to a manageable sizeTeam of 19 research professionals in Edinburgh, Hong Kong and Singapore, providing in-depth coverage on 350 stocks

Pillar Two: Process –

Case Study: First State Global Emerging Markets

They look for firms withSustainable long-term earnings and cash-flow growthTrading at reasonable valuations.To identify sustainable growth, they assess the management, the quality of a franchise, balance sheet strength, and corporate governance.

Fully reflected in portfolioWe find this is borne out in above average long-term forward growth rates, average to below average forward P/E ratios, and the team’s past refusal to participate in hot momentum sectorsLow turnover for a GEM strategy shows the fund adhering to long-term orientation

Pillar Two: Process –

Case Study First State Global Emerging Markets

Is this research reflected in the portfolio in a way that it can have impact?Yes: portfolio construction is largely unconstrainedFinancials weight is only 1/3 the category average, Utilities weight is 4x the category averageFund is notably underweight in Energy and Materials, but overweight in Consumer GoodsThese types of positions are consistent through timeSouth Africa and India are top two country exposures, but not too large—circa 12% eachCirca 100 holdings with top positions running at 5%

Portfolio biases match what we would expect given the fund’s strategy—emphasis on higher quality, more predictable names and sectors

Pillar Two: Process –

Case Study First State Global Emerging Markets

Pillar Two: Process –

Case Study First State Global Emerging Markets

What are the fundamental risks:Fund’s unconstrained nature means its performance will deviate notably from benchmark and peers

We expect it to underperform substantially in markets led by momentum or lower-quality fare

But we also believe the assessment of fundamental risk by the team is strong and believe the emphasis on quality and sustainability of earnings will help the fund outperform in down markets

Pillar Two: Process –

Case Study First State Global Emerging Markets

Conclusion: Process earns our highest scoreStrategy is robust and is consistently applied in the current portfolio and through timeEven when their style is out of favour (as in 2005 and 2007), the managers stick to what they believe works in the long termThe strategy employed is well matched to the resources at handThe fund’s performance in different market conditions is highly consistent with what we would expect given the processAsset bloat needs watching, but no signs that alarm us yet

Pillar Four: Performance

Not a simple screen—evaluate performance within context of our expectations for fund given the investment approach

Risk/return with a long-term emphasis

Behavior in different market environments

Separating skill from luck

Pillar Four: Performance –

Case Study First State Global Emerging Markets

From our process discussion, we expected this fund to outperform in down markets and to lag in momentum-driven or low-quality led rallies.

If the manager’s thesis is valid, however, it should outperform through time.

Pillar Four: Performance –

Case Study First State Global Emerging Markets

Pillar Four: Performance –

Case Study First State Global Emerging Markets

Pillar Four: Performance –

Case Study First State Global Emerging Markets

Fund is doing exactly what we would expect: Capturing most of the upside of the peer group with notably less downside risk.

Pillar Five: PriceExpenses: a reliable predictor of long-term performance

With all the uncertainty in investing, control what you can

Trading costsBrokerage commissionsMarket Impact costs

Structure of performance fees evaluated

Qualitative Research at Morningstar24 Years of independent qualitative research = tremendous

institutional knowledge

Rigorous research into fundamentals, informed by global and local expertise

World class data down to the individual security level to support research

Quantitative research team lends further support as needed.

Ratings Reports are fully transparent. They give a clear rationale for the rating and help users understand how to use a fund in a portfolio.

1000+ funds under coverage and rising. ETF & Investment Trust Research underway

Investors come first