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Split decisions

The rationale behind fund classification is clear but not without its problems

From time to time, disgruntled IFAs have a pop at the Investment Management Association’s sector classification system. Everyone is entitled to their opinion but what is perhaps lacking is a viable alternative to the current system.

Yes, we have heard the calls for splitting up the UK all companies sector and sorting out the bond sectors but it is not as straightforward as it might seem. The committee that oversees the classification system welcomes views from others but these are not as forthcoming as might be expected and often follow on from public complaints.

Any sensible discussion about the fund sectors should begin with a look at why the current system is structured in the way it is. The answer is simple. Sector classification is aimed at the investor, who needs to be able to compare like with like. The main purpose is to provide groups of similar funds whose performance can be compared fairly by investors and their advisers.

The committee overseeing sector classification follows four key principles. First, uniformity in the way that data is prepared and presented. Second, continuity on the basis that frequent change is disruptive and confusing but, more important, will reduce the usefulness and meaningfulness of the data. Third, intelligibility as it is recognised that subjective interpretation of data impacts on its usefulness. And fourth, independence so that comparisons can be made distinct from commercial considerations.

Sector classification is also based on the belief that the typical retail investor wants either regular income or capital growth. The boundaries between the two can be blurred but marketing literature generally makes this distinction and most investors approach their investments on this basis.

Once funds are separated in this way, they are further split according to the type of asset in which they invest, with geography taken into consideration to differentiate UK from non-UK assets.

This forms the basis for the IMA’s sector classification along with a standard 80/20 split in favour of the asset on which the fund focuses. This provides for a sufficient amount of flexibility to allow the fund to be run practically on a daily basis. A different split would run the risk of funds jumping between sectors due to temporary asset allocation shifts and losing their performance history as a result.

The fluidity of the investment landscape means that changes will have to be made from time to time so that the sectors can keep up with market developments.

This should demonstrate the rationale behind our sector classification, showing that it is a robust system based on clear guidelines giving investors what they need while allowing fund managers to run their funds without undue concerns about the impact of their decisions on the way in which their funds are classified.

Going back to one of the age-old cries for reform – that of the UK all companies sector, whose size causes concern for many IFAs – this is surely inevitable as it is our home market. It has been suggested that it should perhaps be broken down into a number of sub-sectors. On the face of it, this might seem a sensible idea but it would inevitably result in a vast number of sub-sectors, each including a small number of funds.

There might also be more likelihood of funds moving between sub-sectors. This would not allow them to retain their performance track record, which not only has an impact on the marketing of those funds but also on investors trying to choose between funds.

Another rule of thumb for classification is that for a sector to be meaningful, there have to be a sufficient number of funds in it so as not to negate the value and usefulness of comparisons.

The rationale behind the IMA sector classifications is clear but admittedly not without its problems. However, the IMA believes it is operating the most effective system which serves the interests of investors, advisers and fund managers.

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