With morningstar Canada officially launching its own classification system for the Canadian mutual fund industry this month, Canadian investors and fund companies must contend with two new and improved fund categorization schemes.

There are several differences between Morningstar’s system and the alternative launched by the Canadian Investment Fund Standards Committee last July, replacing the scheme that had been in place since 1998.

Having two competing systems in the marketplace could cause some problems when it comes to consistency in fund performance rankings and comparative analysis of similar funds, industry participants say.

Rankings and fund categorizations affect many aspects of investing, from investor demand for the funds and marketing to manager compensation and asset-allocation decisions.

“With each categorization system having multiple categories, and different criteria to qualify funds for these categories, there is potential for a lot of confusion,” says Dan Hallett, a fund analyst and president of Windsor-based Dan Hallett & Associates Inc.

For example, a particular fund may be ranked in the top quartile within a specific category by Morningstar’s system, but not by CIFSC’s because the latter has different parameters for defining the membership of the category.

“What if, the following year, the fund no longer qualifies as top-quartile under the Morningstar system, but it does under the CIFSC definitions?” Hallett asks. “It could be suspicious if the fund company keeps promoting the version that puts them in the top quartile. It seems that a fund company would have to make a commitment to one system or another, but you could still have different companies using different categorization systems.”

Morningstar, a provider of Canadian fund performance data and ranking information, announced its abdication from the CIFSC last February due to differences about how funds should be classified.

The CIFSC is a volunteer organization with about 15 members, including the Investment Funds Institute of Canada, Fundata Canada Inc. and the Canadian Life and Health Insurance Association

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A variety of issues had made fund categorization more complex, including the growth of income trusts and their inclusion in the S&P/TSX composite index, and the proliferation of new types of balanced and income funds. In addition, the removal of the 30% foreign-content limit in RRSP-eligible funds has raised the question of how much foreign content a Canadian equity fund can have and still qualify as a Canadian fund.

Morningstar was dissatisfied with the pace of change at the CIFSC in adapting its categories to these issues, as well as with the committee’s ongoing monitoring of fund holdings for the purpose of ensuring that funds remain in the appropriate category. Although Morningstar president Scott Mackenzie had been the founding chairman of the CIFSC, Morningstar members defected from the committee in the belief that Morningstar had the resources to define and monitor fund categories more effectively on its own than through the sometimes cumbersome committee process.

“It’s disappointing that Morningstar withdrew — it’s like a member of the family deciding to go off on their own,” says CIFSC chairman Ralf Hensel. “We are still negotiating with Morningstar to come back, and have been from the beginning. The talks have been positive, but there are still some issues to be resolved in coming up with a system that works for both parties. In the meantime, we have a dual system, and fund companies will have to decide if they want to support one or the other, or both.”

Currently, fund companies are required by regulators to disclose each fund’s category in the fund prospectus, but there is now some question of which categorization system to use, says Hensel.

“Minor differences in category definitions could result in a different classification under each system for the same fund, and that’s a point of concern,” Hensel says. “How to clarify that for investors may be a subject for the regulators to tackle.”

As an example of the differences, both Morningstar and the CIFSC have broken down the Canadian equity category into subgroups. Under the Morningstar system, the categories include Canadian equity, in which 90% of the holdings must be domiciled in Canada, and Canadian anchored equity, in which 50%-90% of the equity holdings must be Canadian.

On the other hand, the CIFSC has three Canadian equity categories, including Canadian equity pure, in which 95% of the assets must be Canadian equities; Canadian equity, in which 70%-95% of the assets must be Canadian; and Canadian focus equity, in which 50%-69% of the assets must be Canadian.

@page_break@Although the CIFSC has a separate category for income trust funds, Morningstar has invented a new category called Canadian high income equity, containing all funds holding equity securities with a high yield, including dividend-paying common stocks, preferred shares or income trusts. Inclusion in the category is based on the yield of the underlying investments in the fund, and it is not relevant whether or not the fund pays out a regular distribution to unitholders.

To determine fund asset mix, Morningstar calculates all fund holdings based on a time-weighted average basis, with more emphasis on recent data. The most recent 12-month period receives a 50% weighting, the next most recent 12 months receive 30% and the oldest 12 months the remaining 20%.

Alternatively, the CIFSC measures portfolio content based on median holdings over a three-year period, with equal weight given to each year. The more than 5,000 available funds will be reviewed monthly under the Morningstar system, and quarterly under the CIFSC’s. IE