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31 May 2012

IMA’s proposals for the future of the Absolute Return sector

Investment Management Association 65 Kingsway, London, WC2B 6TD Tel 020 7831 0898 www.investmentuk.org

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Table of contents

Executive Summary……………………………………………………………………..3

Absolute Return paper…………………………………………………………………5

Proposals for comment………………………………………………………………13

Conclusions and Timetable…………………………………………………………18

Schematics……………………………………………………………………………….…19

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Executive Summary

The IMA sector was created in April 2008 after protracted discussions on many aspects of its design.

The Absolute Return sector is different from most other IMA sectors in that it is outcome focused rather than asset based. The existing IMA Absolute Return sector has two main criteria within its definition: the aim to produce a return of more than zero; and to do that within rolling periods of 12 months (therefore regardless of market cycle).

The Absolute Return sector did not have an obvious place in the classification scheme when it was launched. It was however agreed that it should not sit within the more traditional asset based sectors and by default was placed in the Specialist sector group [Part 2, page 7].

The sector contains a caveat - users should not make performance comparisons of funds classified to the sector. There is no asset based monitoring of funds within the sector.

Since creation there have been 3 reviews. Each one has underlined the different and often opposing views expressed by members on how to define, name and monitor the sector [Part 3, page 8].

The primary purpose of this review is to make comparisons easier for consumers. Most advisory firms will use their own selection methodology but there should be benefits for them too.

In considering the proposals members should bear in mind the changing trends in saving and investment patterns and the implications that this has in terms of both the Absolute Return sector but also for the on-going sector scheme. Industry observers predict a shift to more outcome orientated investment, including greater use of “solution” style funds. At the same time, there is likely to be a continued trend towards the launch of more sophisticated “hedge fund” like strategies being wrapped in UCITS [Part 1, page 5].

The review considered a number of options in relation to taking the sector forward including sub categorisation, no change and abolition. It also considered the approaches taken by other sector schemes.

Each consideration put forward by IMA members has a number of pros and cons. This review therefore sought to close a gap in the knowledge base by conducting research with consumers and advisers.

The research showed the ways in which consumers and advisers are using Absolute Return funds to shape their investment portfolios. It also provided valuable insight into their expectations and their experience. The proposals set out in this paper draw upon the views expressed in this project. Further quantitative research is planned to validate the issues arising from one or more of the options under consideration [Part 4, page 11].

Three proposals for developing the Absolute Return sector are put forward for comment: 1) To sub divide the existing sector by cash benchmark(s) 2) To sub divide the existing sector by hedge fund style categories 3) To retain one large sector but rename and redefine it, alongside providing additional

information on the IMA consumer website (launch Summer 2012) to filter on a number of criteria

[Full details in Part 5, page 13]

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Responses to the consultation are sought by close of business Tuesday 3 July 2012.

Following receipt of comments the IMA expects to discuss the results of the consultation at the next Sectors Committee meeting. If there is a reasonably clear course of action following that meeting, IMA staff will begin work with the independent researchers on the quantitative phase of the research, aiming to test out and validate some key aspects of the results.

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INTRODUCTION

The IMA with the Sectors Committee has been conducting the fourth review of the Absolute Return sector. The primary purpose of the IMA’s approach to sector classification remains to provide groups of similar funds whose performance can be fairly compared by consumers and their advisers. This and the positioning of the Absolute Return sector within the classification scheme has been a key focus of the review.

In addition the IMA has sought to fill a gap in its knowledge by conducting research with end users of the sector.

This paper describes what the review has covered and sets out proposals. It is divided into 5 parts. The first considers the wider context in which change in the industry and to the funds is taking place. The second looks at the sector definition and where it fits within the overall sector classification scheme. The third considers the various ways in which the sector may be divided, and whether these would meet the objective of offering broadly like-for-like comparisons within the sub-divided groups. The fourth looks at the user perspective and considers associated relevant issues. The fifth sets out several proposals for change on which members comments are invited. We then conclude with a note of expected next steps and approximate timetable.

PART 1: THE MACRO VIEW

Background

The Absolute Return sector is different from most other IMA sectors in that it is outcome focused rather than asset based. As such funds are not monitored apart from an assessment of suitability by the Sectors Committee at the point of entry. Many funds in the sector have been developed since the introduction of the third UCITS Directive, which specifically permitted funds to use derivatives for investment purposes rather than limiting their use to hedging or Efficient Portfolio Management.

The Absolute Return sector was created in April 2008 after extensive and painstaking consultation with IMA members. A number of different views on how to define, monitor and name the sector were expressed. The IMA agreed from the outset that the sector would be reviewed annually to assess whether it could be brought to maturity - to allow performance comparisons and settle on a permanent home for the sector within the classification scheme.

As a reminder, the primary purpose of IMA’s approach to sector classification is to allow consumers

and advisers to compare the performance of groups of funds on a like for like basis. However, contrary to this, at the point at which the Absolute Return sector was created IMA advised that performance comparisons should not be made. Although funds in the sector all had a similar aim, the diverse nature of other characteristics such as their benchmarks and investment strategies made performance comparisons inappropriate. Nonetheless, it was considered that comparisons on other factors such as minimum investment levels, charges, manager tenure, asset type, turnover and performance relative to the stated aim and chosen benchmark could be made.

New sectors are typically created using a bottom up approach, in that the sectors reflect the demand for different types of funds as interpreted through the eyes of the fund managers and manifested in new fund launches. Ahead of the launch of the Absolute Return sector there was extensive

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consultation with IMA members. While there was disagreement on a number of aspects there was an apparent strong demand for a new sector styled on a different basis from existing asset-based sectors. However, at the point at which the sector was created there were about 17 funds. Today there are nearly 80 funds classified to the sector. In retrospect, this rather confirms the point that the process was more top-down than bottom-up, and that some of the funds have perhaps fitted themselves to the definition rather than the definition fitting round them.

The bigger picture

One thing that we are keen to address in this review is the changing nature of the market and the longer term impact that this may have on the structure of the sector scheme.

The wider context of this review should therefore take account of significant changes in saving patterns, which in the UK market is characterised primarily by a shift from defined benefit pension provision to defined contribution products. In effect, saving for the future is seeing investment risk moving to individuals, with the employer role shifting from guarantor to facilitator.

At the same time, there is also a context of a continuing secular bear market and constrained

household incomes, both of which will impact on savings products and consumer choices.

Industry observers predict a shift to more outcome-orientated investment, including greater use of “solution” style funds. Typically this space has been filled by funds in the managed sectors and to some extent this is expected to continue. However, alongside the more traditional asset based funds, outcome focused products are also expected to increase, and more rapidly. This outcome orientation will likely take many forms, and may not always be explicitly related to cash or inflation benchmarks. However, the trend is currently anticipated to result in a greater quantum of assets being subject to positive return objectives, i.e. moving beyond relative performance investment market indices. Funds of this nature may already be seen in the retail industry. More particularly, they have entered the DC pensions arena, where concerns over consumer responses to volatility has perhaps driven the attempt to create a smoother trajectory in the accumulation phase.

A further driver of absolute return growth in the funds world may also be the trend towards more sophisticated ‘hedge fund’ like strategies being wrapped in UCITS. The continuing convergence between the mainstream and alternative parts of the asset management industry is not just a one- way journey of greater use of derivative instruments or the introduction of long/short techniques in the established funds industry. It is also characterised by hedge funds moving towards the comfort of heavily regulated fund vehicles, a possibility now that the investment strictures for the regulated products have been widened considerably by regulators. The likelihood, therefore, is of a significant cluster of different kinds of fund that have similar cash or inflation related objectives, but very diverse investment engines within the underlying strategies.

IMA members may have other views on how the funds’ market could develop, particularly those who have launched target/capped volatility funds or have a suite of risk/return targeted client products (including some currently sitting in the Unclassified sector). The IMA is keen to take other views into account in this consultation and urges the referenced funds to respond.

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PART 2: ABSOLUTE RETURN DEFINITION AND THE CLASSIFICATION SCHEME

Sector definition

The IMA Absolute Return sector has two main criteria within its definition: the aim to produce a return of more than zero; and to do that within rolling periods of 12 months (therefore regardless of market cycle). The benefit of creating the sector is that it allows a group of funds sharing a similar aim to be grouped together. The issue now facing us is whether the shared aim and the time period are enough to bind the funds together and allow comparisons to be made between them, particularly performance comparisons.

The sector classification scheme

The Absolute Return sector did not have an obvious place in the classification scheme when it was launched. It was however agreed that it should not sit within the more traditional asset based sectors and by default was placed in the Specialist group of sectors.

If, as predicted by the industry, outcome focused funds are set to grow, it would seem that the classification scheme should accommodate a wider range of funds other than just Absolute Return. It is possible, or probable, that many of these outcome focused funds will be designed to meet future pension and long term savings needs. They may in some cases be developed to sit within a suite of “default” options offered by employers, platforms or advisers. As with the mixed investment funds, some outcome focused funds could be developed as a form of “solution” for the investor, rather than being one element in a wider portfolio of assets. This, together with the choice of a UCITS/authorised fund structure tends to indicate that at least some, if not most, of the outcome focused funds in the future will be distributed as mainstream retail funds.

The Absolute Return and other outcome focused funds use derivatives for investment purposes, which prior to UCITS 3 was a freedom denied to authorised funds. Although there has been disappointment with the Absolute Return funds, as a sizeable number of funds in the sector have not always met their aim, this is not unique to the Absolute Return sector. It is however more pointed in the Absolute Return sector in that expectation is focused on the specified aim rather than on the type of the holdings.

A valid question therefore is whether the Specialist area in the classification scheme remains the best place for the AR sector. The Specialist sectors have typically comprised a “nursery” sector, where funds are gathered until there are enough of a particular kind to be able to draw out a new sector (for example, the Property sector was drawn from the Specialist “nursery” sector). Other sectors within Specialist are effectively narrow focus, for example the Tech and Telecom sector.

Sector reviews

Since the creation of the sector there have been three annual reviews.

At the first review of the sector it was agreed that the timeframe was sufficiently important to move it out of the notes into the main body of the definition.

At subsequent reviews adherence to the timeframe remained a focus. This required that funds classified to the sector should clearly state in their literature that they had a rolling 12 month

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timeframe for delivery of the absolute return. This then became a requirement for entry to the sector by the Sectors Committee and a “soft” monitoring requirement.

In the third and fourth reviews we analysed a considerable range of data and sought views from the members on the best way forward. There has and continues to be a range of opinions in the membership about what should be done with the sector. The options discussed and debated include:

1. Volatility measure 2. Common benchmark 3. Hedge fund style categories 4. No change 5. Abolition

These options are considered further in Part 3.

Other sector schemes

There are many other sectors for funds other than those provided by IMA – and Absolute Return funds are not unique to the IMA sectors.

The ABI does not provide a separate definition for outcome focused funds in its sectors. Instead these funds are classified by asset type into their existing sectors and are flagged as having a specialist strategy.

Other sector providers such as the EFCF (European Funds Classification Forum), Morningstar UK and Citywire have followed a style that is reminiscent of the hedge fund (or “Alternatives”) approach, dividing funds principally by strategy such as Long /Short, Global Macro and so on. This approach requires a larger starting universe of funds than the IMA has and it may be that consumers would find the categories somewhat esoteric. The sector schemes which have adopted the Alternatives approach typically do not monitor the funds within these sectors.

In addition, we note that the Association of Investment Trusts simply groups all investment trusts following Absolute Return or other outcome based investment strategies in a single sector named “Hedge Funds”. There is a degree of simplicity in this approach that is appealing. It should also be readily understood by investors that they are looking at funds that are not traditional in style and not therefore principally defined by their asset content.

PART 3: DEVELOPING THE SECTOR – MEMBER VIEWS

This section sets out the main proposals put forward by IMA member firms for future development of the sector. Mostly these consist of finding ways to divide up the funds in the sector into smaller groups that are sufficiently like in some way to allow performance comparisons to be made.

But first we discuss the issues around timeframe, as these have been raised throughout the life of the sector. We then set out the various suggested sub categories.

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Timeframe

At the initial meeting to discuss the creation and definition of the Absolute Return sector support was expressed by a significant proportion of participants for including a time period for measuring performance. Owing to a number of funds in the sector using a cash benchmark, where common market practice includes investments up to a 12 month maturity, the 12 month timeframe was considered to be the most appropriate. In addition the Sectors Committee came to the conclusion that funds with a focus of greater than 12 months were already accommodated within the Managed sectors (there had originally been a proposal to create two new sectors, the other being a Target Return sector with a timeframe in excess of 24 months).

Introducing a “hard” monitoring test of funds based on their ability to achieve positive returns on a rolling twelve month timeframe was considered but rejected, as non compliance with the sector “aim” was considered to be self evident. There were, and continue to be, legitimate concerns that removal of funds that failed to produce a positive return would create survivorship bias in the sector, which would actively disadvantage consumers/advisers using the sector to get an overview of that style of fund. The proposal to “flag” funds which had failed to meet the sector aim, but remained in the sector, was also rejected by members.

Clearly a sector that is defined by a return-focused aim requires a stable and consistent means by which to measure that return, hence the agreed timeframe. However, that timeframe has also consistently been an area of difficulty within the definition. At entry to the sector there has been regular and sometimes extensive correspondence with a number of funds about their commitment to the 12 months timeframe. Recent investigation has shown that it is often difficult to clearly identify the timeframe for returns from the literature available to the end investor. To sum up, the timeframe remains a point of contention. Some members favour changing the timeframe, others would like to retain it, whilst yet others suggest dividing the sector to allow for more than one timeframe in the definition.

Sub categorisation

A general philosophy of the sector classification scheme has been as far as possible to keep the sectors large and inclusive. This was endorsed in the 2011 sector classification scheme review. It requires the consumer and adviser to do their own due diligence when selecting a fund and is consistent across all sectors, including Absolute Return.

At the first and second reviews there were considered to be insufficient funds to recommend sub division of the sector on any basis. It was also noted that the differences in investment strategy and style within funds classified to the sector were not so very different to what is seen in other large sectors such as the UK All Companies sector, where there is a very diverse range of funds captured within the asset definition.

However, as the number of funds in the Absolute Return sector has grown the Committee has re- visited whether the sector would benefit from further division or redefinition. Member proposals for sub-categorisation (other than timeframe) have to date fallen into four main groups:

i. To sub categorise by asset class (e.g. equity, bonds, mixed assets);

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ii. To sub categorise by taking the existing hedge fund classifications (e.g. market neutral, long/short equity, global macro);

iii. To sub categorise based on “LIBOR +” or inflation benchmarks (e.g. cash+1%, cash +2% …); iv. To sub categorise by using standard deviations, expected VAR or drawdowns as proxies for

risk.

A number of points specifically in relation to sub categorisation have been made in the past:

I. Sub categorisation by asset class, while the easiest to do, does not really help the consumer/adviser when the glue holding the sector together is a particular aim. In some cases it could be actively misleading, if the return profile of the named asset is altered by use of derivatives;

II. Categorisation under the existing hedge fund strategy classifications could be difficult, with

some funds not easy to categorise and at present not enough funds to make each category meaningful. This option would also require some education of the consumer and would introduce monitoring challenges. As mentioned, other sector providers do not monitor the funds in their “Alternative” sectors on an on-going basis. There is also a big question mark about how much information the hedge fund categories convey to consumers; they imply a degree of understanding that is likely to be overstated for unadvised investors;

III. Sub categorisation on the basis of risk requires a sensible and consistent measure to have

been established in the first place and for this to be adhered to by all funds. Introduction of a risk measure would therefore require agreement on the best proxy for risk/volatility. The SRRI measure set by regulators is a start. However it is an absolute rather than a relative measure, there are issues over the timeframe for comparison and it may not provide enough differentiation across funds.

Use of standard deviation or VAR measures based on historic performance data suffer from the “cliff effect”. There is also a likelihood that the risk profiles of funds will change over time, leading to complications over the allocation of the fund to the correct category.

Although the risk/volatility based approach has some attractions, it is considered to be essentially untested and there is a question mark over how well consumers would understand what was being measured. Because of the “black box” approach, it would have to produce no surprises for consumers – the “cliff effect” mentioned above leaves a big question mark over the ability of the risk approach to deliver on this.

Possible abolition of the sector

Previous reviews have considered the abolition of the sector, based on whether it is meeting consumer expectations.

This ignores the strong likelihood that outcome based funds will remain a growth area of the market, and that the asset based sector scheme do not offer a home which can supply a proper basis for comparisons to be made between these types of fund.

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Part 4: THE USERS’ PERSPECTIVE

The IMA sectors have many users. Although principally meant for consumers and their advisers, the sectors are also used by industry analysts, for product development and for management information. This section provides feedback on the first phase of the research commissioned by IMA into the Absolute Return sector. It also addresses issues which are relevant generally to users.

Research about users

In order to further the current review and to fill a gap in the IMA’s knowledge, we felt that it would be useful to establish the views of end users – specifically consumers and advisers - and gain a better understanding of what users think of AR funds. This input has been missing from previous reviews. Accordingly we commissioned independent research from ORC International to help establish on what basis IFAs and consumers choose to recommend/invest in Absolute Return funds, what their expectations were now and had been in the past, and whether the IMA sector definition and sector name effectively aid this process.

ORC were commissioned first to undertake qualitative research with consumers and IFAs. (The IMA expects to conduct quantitative research at a future date.) The qualitative research comprised a mixture of focus groups (2 for IFAs and 1 for consumers) and depth interviews (15 with consumers and 12 with IFAs). The points below are drawn exclusively from the qualitative research. It was notable that there was a drawing together of views in relation to these points between all participants.

Consumer comments

1. Consumers were initially attracted to Absolute Return funds as a safe, low-risk diversification

tool for their portfolio with the expectation that an Absolute Return fund would provide a general smoothing effect on the rise and fall in volatile markets.

2. Complex strategies and a general lack of transparency meant that consumers felt there was

a far greater degree of trust required in the managers’ skill in managing an Absolute Return fund than for other types of funds. There was a feeling that more oversight was needed, including monitoring.

3. There was disappointment when the funds were ineffective in achieving their stated aim –

leaving consumers wary.

4. Comparisons were drawn with previous negative investment experiences e.g. zeros. Consumers also noted that Absolute Return funds limited upside gains (the smooth effect) but that this was a high price to pay when protection against downside risk had not occurred as expected (ie there were losses and the ‘more than zero’ aim was not met).

Adviser comments – IFAs/Panel-formers/discretionary asset managers (DAMS)

1. Advisers perceived Absolute Return funds as a low risk, volatility control tool to provide

balance in a portfolio - although those with more Absolute Return experience were likely to view them as higher risk.

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2. Advisers generally understood that the funds’ objectives were an aim not a guarantee – however, there were a number of comments that funds had typically not delivered on the aim, especially during 2008/9.

3. There was a dis-connect between the sector definition and the sector name. The definition

was well understood, however, the sector name was considered to be misleading – there were concerns that it implied a guaranteed return.

4. The issues around the complexity of the strategies in use by the funds, and the lack of

transparency about these, were common with the views expressed by the consumers.

5. Other issues often raised were: the lack of participation in returns in rising markets and insufficient protection in falling markets; difficulty in benchmarking; high costs; and confusion around the rolling 12 month timeframe.

6. Advisers would also like the sector to be monitored.

Financial Services Authority: Retail Conduct Risk Outlook 2012

Subsequent to conducting the research, the FSA published its Retail Conduct Risk Outlook 2012 report which highlighted a number of potential concerns with Absolute Return funds. These had not previously been noted by the regulator. In line with some of the findings in the qualitative phase of the ORC International research, their comments focused on the potential for misunderstanding by consumers, unexpected losses and inadequate product knowledge by advisers.

Points for consideration drawn from the research

General

It is clear that there is a dis-connect between investor expectations and experience. In light of this there appears to be a desire for greater clarity around the fund characteristics to improve understanding and allow comparability of the funds.

It is also clear that investors are not entirely comfortable with a complete transference of control to

managers. It seems that they would find it helpful to have greater transparency about what the funds are doing, which implies that there is desire for more information to assist decision making. Characteristics that end users identified as helpful to them in making a decision were information about leverage, more on the investment strategy, asset class, benchmarks and, to a lesser extent, timeframe. They also indicated a preference for the sector to be monitored in some way.

Naming

The sector name was also discussed during the research.

At the creation of the Absolute Return sector a number of names were considered; Absolute Return, Constrained Volatility, Target Return, Total Return were a few of the most popular. The decision to use “Absolute Return” as the sector name was based on the view within the Sectors Committee that this was the most widely used term in use by funds which defined the universe and was, as a consequence, likely to provide a higher degree of recognition by the end user.

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Subsequent reviews have considered other alternative names for the sector such as Absolute Return Objective sector. These were rejected as it was concluded at the time that changing the name would not change the perception of consumers or their advisers and that the existing name was by then better recognised.

Monitoring

Most of the existing IMA sector definitions are based on asset constraints and funds classified to them are monitored against these. The IMA Absolute Return sector was the first sector to be defined by an outcome.

As mentioned in the section on Timeframe, there is currently “soft” monitoring of adherence to the 12 month timeframe and the Sectors Committee check funds at entry. However, the research indicated that consumers and IFAs would prefer the sector to be monitored. IMA also would like to introduce monitoring, if feasible, as we believe it enhances the integrity of the sectors.

Availability of information

There appears to remain a need for easy to find factual information about funds. The IMA is developing a new consumer website and we would expect to deliver more information on the sectors generally through the website. In addition, the IMA provides substantial factual information about funds to the data providers, and others, for them to use for their own products.

PART 5: PROPOSALS FOR COMMENT

This section sets out 3 proposals on which comments are invited. The aim is to agree a framework for taking the next steps in regard to the Absolute Return sector.

The three main proposals under consideration are:

1. To sub divide the existing sector by cash benchmark(s) 2. To sub divide the existing sector by hedge fund style categories 3. To retain one large sector but rename and redefine it, alongside providing additional

information on the IMA consumer website (launch Summer 2012) to filter on a number of criteria

Each proposal describes a basic approach below, with the pros and cons of each. It is expected that a lot of the final details will be fleshed out as a result of comments from members but also in response to further research with consumers and advisers. It is likely also that the name of the sector is one area that could be tested through further quantitative research. Suggested names for testing are expressed in each proposal.

It has already been noted that one of the main aims of this review is to identify the correct positioning of the Absolute Return sector within the sector scheme. Therefore, each proposal includes a schematic which shows how the sector(s) would be positioned. A clearer distinction between traditional (asset based) and outcome focused (hedge) funds may be required to encourage an end user to take steps to increase their comfort levels with these relatively new types of funds that may rely more explicitly on manager skill, leverage and so on. Members should consider whether the position of the sector(s) within the framework may help in this regard.

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We note that different approaches may more readily be understood by a consumer or an adviser and, if so, we would like information on this. Members may wish to comment on this aspect of each proposal.

A number of questions are listed at the end of the proposals which prompt members for particular responses. Additional comments are welcome.

Proposal One - subdivide the existing sector by cash benchmark(s)

The approach would sub divide the existing universe of funds to indicate which funds were targeting more stable outcomes. The proxy for this would be based on a cash benchmark(s).

There are about 40 funds which appear to use a cash target/yardstick, a sufficiently large number to create a new sector. The most commonly used benchmark is 3 month LIBOR but a number of other cash benchmarks are used. A number of funds have a cash target built into their performance fee hurdle but otherwise do not state it as a benchmark. Members may want to comment on the latter points.

Funds would be monitored by checking for returns. Those falling outside of cash +/-2% in two consecutive calendar years would be removed.

A small number of funds – about 6 – appear to have cash plus benchmarks. This would not be a

sufficient number to consider creation of an additional cash plus sector at this point in time.

The existing definition would continue to exist as the overall umbrella to the sector. Funds not wishing to elect into/ or not meeting the criteria of the new sub sector would remain here. The “old” sector would require an additional label such as “other”, or perhaps something more descriptive such as “unrestricted”. The suggested structure could be as follows:

Target or Absolute Return – Other or Unrestricted

Funds which aim to deliver positive returns in rolling [12]/[24] month periods. [Funds do not aim to meet a specified benchmark and are not restricted as to choice of investments]

Target or Absolute Return – Cash benchmark

Funds which aim to deliver positive returns in [rolling 12 month periods][each calendar year][each fund’s financial year] and aim to beat a cash benchmark (typically 3 month LIBOR).

[In a note:] Funds which fail to meet the stated aim in one period/year will be flagged. Funds which fail to meet the stated aim for two/three consecutive periods/years will be removed from the sector.

Name of the sector

Possible changes to the name are suggested above. These could be tested in quantitative research.

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Pros of this approach

• It sub divides the universe and allows comparison of funds with similar yardsticks which consumers would naturally use and be expected to understand to make assessments for saving and investment.

• It should provide the consumer/adviser with an approximate idea of the potential volatility of the funds within each sector.

• It responds to the expectation expressed by consumers in the qualitative research that Absolute Return funds were thought to provide relatively low risk portfolio diversification.

Cons of this approach

• Sub division and comparison improves for those funds that fall into the new sector. The

funds left in the unrestricted sector remain eclectic and may still not be fairly compared for performance purposes.

• Further sub division of the remaining unrestricted universe may be problematic. Attempts could be made to create further sub-division based on cash plus benchmarks but, from a sector perspective, there are clear problems with this. For example, historically cash +4% has been used to describe equity type returns over long periods; however we would not expect a consumer to know this.

• Further sub division on timeframe runs into the issues already discussed above. • It is not clear how other outcome focused funds fit into this new framework.

Position in the framework – See schematic 1.

Proposal Two – sub divide the existing sector by hedge fund style categories

This approach would sub divide the existing universe of funds using hedge fund strategies such as long/short, global macro etc. Subject to comments the existing definition would continue to provide the overall umbrella for funds in these sectors.

Fund groups would have to certify the strategy in use within their fund. Classification would be based on the premise that the strategy would not change over time.

Some have suggested creation of an “Alternatives” category heading in addition to the “Specialist” heading - positioning outcome focused sectors under this new label. There are some issues with use of the “alternatives” term as it may raise a question in the mind of a consumer – alternative to what? Absolute Return funds are UCITS, they operate within the UCITS investment restrictions and regulatory framework and are designated retail products (although we note the European regulatory review that is revisiting the distinctions between “complex” and “non complex” products (Commission proposal on review of MiFID, 21 October 2011, COM(2011)656).

Some may also associate the “alternative” label with higher risk investments, which would not be a fair reflection of all funds in the existing sector. Although Lipper analysis of SRRI categories for funds within IMA sectors indicates that Absolute Return funds fall into 5 risk bands, i.e. from the lower risk to the higher risk bands, it also indicates that the AR sector has the biggest proportion of funds which fall into the lower SRRI risk categories.

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Members may want to comment on this. It is also dealt with in the schematics for this proposal which set out 2 choices under two different IMA category headings.

Naming of the sectors

Since this proposal aligns with existing sector schemes (Morningstar UK, Citywire, European Fund Classification Forum), those names would be used, effectively describing the high level strategy of the scheme (for example Long/Short, Global Macro). Alternatively, the existing sector name could be retained, as in Absolute Return – Long/Short, etc.

Pros of this approach

• It is a fairly simple classification approach which only relies upon the firms to certify their

strategy on submission for classification. • A number of other sector schemes have adopted this approach; some may feel more secure

around this “herding” of sectors. • Names that indicate the complexity of the underlying strategy provide a clear delineation

from traditional sectors • It may give some indication of the investment strategy or tools employed within the fund to

provide a return.

Cons of this approach

• There are insufficient funds within the existing universe to meaningfully sub divide the sectors in this way. At the current time it appears that there would only be sufficient funds to create a Long/Short equity sector.

• It would not provide a basis on which to monitor funds, thus would not meet one of the expressed preferences shown in the qualitative research.

• The names and definitions for the sector are thought not to mean much to consumers and may not help them to a better understanding of the nature of the funds gathered together.

• Some of the strategies employed (eg Global Macro) are also used by funds in existing asset based sectors, which could cause confusion.

• It may not encompass all types of outcome focused funds.

Position in the framework – see schematics 2a and 2b

Proposal Three – retain one large sector but rename and redefine, alongside providing additional information on the IMA consumer website to filter on a number of criteria

Under this proposal the IMA would look at redefining and simplifying the sector. A possible definition would emulate that of the AIC as follows:

“ Funds that employ a range of non traditional or hedging strategies but are regulated as UCITS”; or

“Funds that promote an outcome orientated investment strategy and use derivatives for investment purposes”

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In addition, the IMA would provide further information on its new consumer website (to be launched in Summer 2012) within the Fund Directory, allowing users to filter funds on a number of criteria. The criteria could for example include:

a) Assets b) Strategy c) SRRI/Risk/Volatility d) Drawdown e) Leverage f) Benchmark g) Beta h) Other criteria

Naming of the sector

Consider changing the name of the sector to: Outcome Orientated, Target Funds, Hedge Funds, Alternatives – to be tested in consumer/adviser research.

Pros of this approach

• The existing universe of AR funds is eclectic. There are a range of risk characteristics,

strategies and asset types resulting in very different performance results. Under this proposal the end user identifies the characteristics that are important to them – and compares funds based on those characteristics.

• It eliminates the issues on timeframe mentioned above. • It provides a wider definition than currently. This may not be seen as a positive but it deals

with a suspicion that many firms market these products as a unique approach to investment. The filtering allows for comparisons on a number of different criteria and removes the likelihood that funds are engineered to fit the definition.

Cons of this approach

• This approach may not deal with all types of outcome focused product. • It could categorise funds using a wide range of investment styles and with different risk

profiles without differentiation. • This approach does not allow any monitoring of funds within the sector. • The additional information may in reality only be shown on the IMA website (although IMA

would make it available to data vendors) and not therefore have as widespread use by consumers as desirable.

Position in the framework – see schematic 3

Questions for members in relation to proposals:

1. Please comment on your preferred proposal with reasons, including name, favoured schematic

and any key variances or additions you believe are necessary. You may also wish to consider combining factors from more than one of the proposals.

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2. If you have an alternative approach which is not covered, please comment but also consider whether it could be accommodated within any of the above or has been covered in the wider paper.

CONCLUSION AND TIMETABLE

Responses to the consultation are sought by close of business Tuesday 3 July 2012. If you wish to discuss any aspect of the paper, please contact Nicola Kembey, Head of Sectors, at the email address below, or by telephone. Please send written comments by the deadline to nkembey@investmentuk.org

Timetable

Following receipt of comments the IMA expects to discuss the results of the consultation at the next Sectors Committee meeting. If there is a reasonably clear course of action following that meeting, IMA staff will begin work with the independent researchers on the quantitative phase of the research, aiming to test out and validate some key aspects of the results. The further research will then take place in the third quarter. Subject to the obvious uncertainties of this timetable, IMA will discuss final proposals with the Sectors Committee and communicate with the IMA Board, and others if necessary, with a view to publishing conclusions in the fourth quarter.

IMA Absolute Return review Schematics:

Revised classification chart

May 2012

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Current Schematic

All Funds

Asset Based sectors Specialist Sectors

- Absolute Return - Personal Pensions - Property - Specialist - Technology &

Telecommunications

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Schematic 1

All Funds

Asset Based Sectors Specialist Sectors

Asset Based Outcome Focused Nursery

Property Tech and Telecomm

Target or Absolute Return Existing specialist sector

Target or Absolute Return – Other or Unrestricted Target or Absolute Return – Cash benchmark

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Schematic 2a

All Funds

Asset Based Sectors Specialist Sectors

Asset Based Outcome Focused Nursery

Property Tech and Telecomm

Absolute Return Existing specialist sector

(Absolute Return) – Long/Short (Absolute Return) – Global Macro etc

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Schematic 2b

All Funds

Asset Based Sectors Specialist Sectors Alternatives

Asset Based Nursery Outcome Focused

Property Tech and Telecomm

Existing Specialist sector

Absolute Return

(Absolute Return) – Long/Short (Absolute Return) – Global Macro etc

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Schematic 3

All Funds

Asset Based sectors Specialist Sectors

Asset Based Outcome Focused Nursery

Outcome Orientated/ Target Funds/ Hedge Funds

Filters on: Assets Strategy SRRI/Risk/Volatility Drawdown Leverage Benchmark Beta Other criteria

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