Why the IMA sectors need redefining

The IMA sectors have been a bastion of stability for over a decade, providing a structure to compare funds against their peer group. But they now need changing.

As the industry has evolved the scope for differentiation of funds within sectors has increased exponentially, to the point where in some cases the comparison is almost meaningless. With a review of the sectors on the cards, many aspects need to be revisited to ensure that sectors remain relevant.

The IMA sectors aim to provide a framework where funds investing in the same things can be compared fairly. To achieve this they define each sector in terms of what the fund invests in; this process has worked admirably for many years but has had some unintended consequences.

As sectors have become ingrained in investors’ psyche, some have emerged as more popular than others. Marketing departments everywhere understand the importance of being in the right sector to increase their funds’ assets.

Evolution

In some cases, sector definitions have evolved into constraints that have hampered managers’ flexibility. A fund in the IMA Active Managed sector might wish to hold more cash than is permitted at times of market stress; conversely balanced managed funds might wish to hold more equities when markets are rising.

Restrictions are meant to ensure funds in a sector are comparable, but focusing on asset allocation is perhaps not the best way to achieve this. The IMA Cautious Managed sector, for example, requires funds to hold a maximum of 60% equities and a minimum of 30% in fixed interest and cash; potentially a fund could hold 60% small cap equities and 40% high yield debt and be compared to a fund with 40% large cap equities and 60% cash.

This situation is mirrored across most sectors, where funds pursue different strategies and behave in different ways despite notionally investing in the same things.

Statistics

This is borne out in the statistics from the Cautious Managed sector. According to Financial Express data, the best-performing fund over the three years to 13 August 2010, the CF Ruffer Total Return fund, made 47.37% while the worst performing, the IFDS Chartwell Balanced Income fund, lost 21.07%. The sector’s distribution of three year returns has a high standard deviation with fat tails, indicating that the number of extreme results is above normal.

Disconcertingly, the amount of risk being taken by these funds is extremely disparate. The fund displaying the most risk, the Henderson Managed Distribution fund, has a three year volatility figure over four times greater than the fund with the least risk, the Barmac Castleton Growth fund.

This situation is repeated across several sectors, including the IMA UK All Companies, IMA Specialist, IMA Global Growth and the remaining IMA managed sectors which suffer from broad remits. The property sector meanwhile has a mix of funds investing in physical properties and shares in property companies, which clouds the performance picture.

This level of disparity not only makes comparisons of funds difficult, it also causes confusion for investors. The level of risk considered cautious will obviously vary and this is not addressed within sector criteria; investors’ differing expectations may mean they end up with unsuitable funds.

Component parts

The IMA is considering splitting the broadest sectors into sub components to better isolate funds with similar objectives. This will go some way to solving the problems associated with comparing apples and oranges, but it will also greatly increase the number of sectors and add to the complexity of fund selection.

The IMA should examine the fundamental purpose of sectors and analyse how advisers and investors use them. While accurate peer group comparisons are valuable, are they the core reason investors use sectors? Splitting the sectors further assumes that investors have a detailed asset allocation strategy, that they have already identified UK Mid Cap equities as an area they want exposure to for example, and are now researching possible funds. This is unlikely to be the way most investors approach fund selection.

Instead, this review should investigate the need for such a detailed sector set. The sites like Trustnet.com means that investors are capable of doing their own analysis against a range of benchmarks and peer groups, thus reducing the value of sector analysis. Additionally the high correlation of equity sectors reduces the value of further segmentation.

Solutions

Perhaps a better solution would be to match up funds in each asset class with a specific risk level. If an investor is seeking equity exposure, a diversified portfolio of international equities should serve that purpose; the real question is how much risk to take. By grouping equity funds by risk it will be easier for investors to match funds to their needs.

The growth of defined contribution and self invested personal pensions means there are now far more people picking funds without professional advice and RDR is likely to accelerate this trend.

How best to assist investors to implement their strategic asset allocation should be high on the IMA’s list of priorities, although they are financed by their members and will need to take their views into account. Ucits and RDR are rapidly transforming the industry beyond all recognition from the one that witnessed the last large scale review in 1999, and the IMA should not be afraid to come up with a solution that is as radically different.

Rob Gleeson is an analyst at Financial Express