When Morningstar Canada last year broke away from the Canadian Investment Funds Standards Committee (the research organization that defines and classifies mutual funds) and launched its own fund classification system last October, it set the stage for two competing schemes and a confusing environment for advisors and investors alike.

The two systems have the potential to cause problems, ranging from making it difficult to conduct proper fund comparisons to determining consistency of fund performance. For example, a fund might rank highly in one system but not in another (see story, above).

Fortunately, these problems could soon be resolved. After three months of meetings, the two sides are close to implementing a single set of classifications that may be unveiled this spring or early summer.

“I’m optimistic we’ll be able to find common ground to supply a single set of categories for the marketplace,” says Scott Mackenzie, president and CEO of Morningstar Canada in Toronto.

Mackenzie is in talks with a core group at the CIFSC that includes representatives from CANNEX Financial Exchanges Canada Ltd., Fundata Canada Inc. and Globe Interactive, a unit of the Globe and Mail.

“We’re dealing with the details right now, such as what will be the best set of categories,” Mackenzie adds, adding that no target date has been set. “We’re at least 80% of the way there — north of that.”

Ralf Hensel, chairman of the CIFSC and senior legal counsel at the Toronto-based Investment Funds Institute of Canada,won’t stick by the 80% figure but does say the talks are very amicable and agreement has been reached on the fundamentals.

“The real key is [dealing with the fact] that the CIFSC has 38 fund categories and Morningstar has 52,” says Hensel. “There has to be a common number, and we have to figure out which categories make the most sense. Everyone agrees that the only logical, proper solution is a single standard. It doesn’t serve the investors very well to have two separate standards.”

Not surprising, fund companies welcome this development. “We strongly encourage the CIFSC and Morningstar to come back together and work toward a single standard for fund categorization,” says Jonathan Hartman, vice president of investment products with RBC Asset Management Inc. in Toronto. “It’s in the best interest of inves-tors, advisors and the fund industry at large that we return to, and maintain, a single standard.”

Too often, Hartman adds, there is confusion among advisors when they try to examine comparable funds and see differences in how they are categorized in the prospectus. “A single system makes sense,” he says. Given that clients and advisors are all busy, it’s not productive to have two systems.

“There is a lot of work and effort spent on looking at the differences between the two systems and how we assess our funds’ relative performance,” says Hartman. “We are spending a lot of time trying to ‘marry up’ the differences in these two systems. There are better ways to spend our time in supporting advisors in the delivery of investment solutions,”

Peter Anderson, CEO of Toronto-based CI Investments Inc. , notes that his firm’s preference is for a single, consistent system. But he also admits both systems have their merits.

“We like, for instance, how Morningstar has responded to the end of the foreign-content limits with the ‘Canadian equity’ and ‘Canadian anchored equity’ categories, compared with the CIFSC approach,” says Anderson.

On the other hand, he says, CI is concerned that Morningstar’s 52 categories may be excessive.

Anderson admits that he has not heard advisors complaining that the existence of two systems is a major issue for them. But he does speculate: “Perhaps it will lead to less emphasis on the peer group and more emphasis on the individual portfolio manager and whether the fund is meeting the advisor’s and investor’s expectation of risk and returns.”

While advisors may not have been worked up about the development of two parallel classification systems, Mackenzie has been very disturbed by the way the CIFSC was going, and argues that Morningstar’s departure from the CIFSC, and the creation of its own system, was inevitable.

As a founder of the CIFSC, Mackenzie quit the organization last February out of frustration because he believed the committee had become complacent and “borderline dysfunctional.”

@page_break@Changes needed to be made, and greater rigour to monitor the fund categories “simply was not happening,” he says. “I tried very hard to go forward — unsuccessfully. That’s when I decided to leave.”

INAPPROPRIATE FUNDS

For example, he notes, under the CIFSC’s standards some bond funds managed to get into equity fund categories. “If these categories are not properly monitored, we are including inappropriate funds in any comparative analysis,” he says. “That’s why we felt so strongly about it.”

Another bone of contention was the slow pace the CIFSC adopted in dealing with the redefinition of Canadian equity funds following the removal of foreign-content restrictions.

“Ironically, I don’t think there was any disagreement by any committee members that this had to be done,” says Mackenzie. “It was just the speed at which it was being accomplished. There was no progress made at all, month after month.”

Today, happily, he says, there’s been a shift in attitude within the CIFSC toward finding compromises and moving forward: “There is a real commitment on both sides to make this work.”

Hensel concurs and notes that, over the past year, changes have occurred within the industry that will have to be reflected in the new categories. For instance, the CIFSC had a 70% Canadian-content threshold in its Canadian equity category. “We have to respect history to some extent,” he says, “because there had been a fixed limit for so long that fund companies could not overnight release the brake, so to speak, and have their funds go up to 80% foreign — that would not serve investors.”

As fund companies are slowly adjusting their Canadian funds’ foreign exposure, the CIFSC and Morningstar have to look at this area more closely and clarify the definition of “Canadian equity” funds.

The same approach has to be used with categorizing income trusts, now that they have lost their taxation advantage — thanks to last fall’s new rules — and many are expected to convert to corporations.

“There are a number of things that need to be reflected in the new categories,” says Hensel. “It’s a perfect time to do this. I think we can build almost a perfect set of categories.”

And, just as important, once that set of categories is determined and announced, he stresses, the collaborative approach is the way to go. In other words, rather than dictate to fund companies how funds should be classified, the CIFSC is seeking input from them.

“Is it going to work for you or not? We will react accordingly and make adjustments,” Hensel says, adding that both the CIFSC and Morningstar have done that in the past year.

The two sides had better move quickly, if some analysts are to be believed. Gordon Pape, publisher of the Toronto-based Internet Wealth Builder, notes there are far too many categories to begin with and that Morningstar is the least user-friendly of the two systems.

“For the casual investor, you’ll have a heck of a time trying to find your fund in either grouping,” says Pape. “When I look for the ‘balanced fund’ category at Morningstar, for instance, there is not a single category that has the word ‘balanced’ or ‘asset allocation’ in its name. You have to decipher what Morningstar is saying.”

For the record, Morningstar has categories known as “Canadian neutral,” “Canadian neutral portfolio,” “Canadian fixed-income tilt” and “global neutral portfolio” that all come under the “balanced fund” classification.

DIFFERENT CATEGORIES

“Why would an ordinary investor look for BMO Monthly Income under something called ‘Canadian neutral portfolio’? There is no logic to it,” says Pape. “Why isn’t CIBC Monthly Income Fund there, too? That CIBC fund is in the ‘Canadian portfolio’ category. Here you have two funds that people could be trying to compare, but they’re sitting in different categories.

“There is no way that a casual investor is going to click intuitively on ‘Canadian portfolio’ to look for balanced funds,” he continues. “It doesn’t mean anything. That situation is very confusing.”

Meanwhile, Pape is also critical of the CIFSC. He points to its nine “balanced fund” categories: “Even if you’re a professional, trying to compare apples with apples, how do you know where to look? These divisions become arbitrary. You could get a situation in which a fund could be in ‘Canadian balanced’ one year, but appear the following year in ‘Canadian balanced fixed-income’ because of market changes.”

Pape agrees there have to be enough categories both to make fair comparisons and identify the funds correctly. “But neither of these two systems is addressing this to a satisfactory degree at this time,” he says, adding that, at the very least, a new system should have user-friendly names.

But fund analyst Dan Hallett, president of Windsor, Ont.-based Dan Hallett & Associates Inc. , disagrees. He argues that advisors have to accept that no classification system is perfect and there’s no reason why they can’t work with the one with which they are comfortable.

“I think it is fine to have a choice,” he adds. “Personally, I strongly supported Morningstar’s endeavours to create a better system because I found myself occasionally puzzled by the way the CIFSC categorized funds.”

As an example, he notes, Standard Life Canadian Small-Cap and Beutel Goodman Small-Cap were once categorized as “Canadian equity pure.” The error has since been corrected: both funds are under in the “Canadian small-cap” category in the CIFSC system. IE