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S&P Fund Ratings Process Look for consistent, above-average performance At Standard & Poor's, we identify investment funds that have provided consistently strong performance year after year relative to a meaningful peer group. Compare apples to apples The first step is to ensure that funds are being compared to an appropriate peer group. When shopping for a luxury car, you don't measure the features and price of a Mercedes against those of a Volkswagen. Instead, you might look for comparative information on other luxury cars - Audi or BMW. In the same way, it makes no sense to compare two very different types of investment funds. At Standard & Poor's, we know that careful fund categorization is important for investors and investment professionals building asset allocation programs. That's why we compare funds only to other funds that are similarly managed. We compare funds on the basis of their objectives using portfolio level reviews to ensure homogeneity of universes. Identify consistent performers in each asset class What's in a cumulative performance record? Look at any list of top-performing funds and you'll likely find a few that have achieved their results on the strength of one spectacular year. In some cases, top-ranked funds have turned in mediocre or even poor results in two out of three years. Investors and investment professionals who choose them are effectively betting that lightning will strike twice - and that managers will be able to duplicate their single exceptional year's return. Often, last year's star is this year's laggard. And yet, many investors will choose funds simply based on recent high returns. They may ignore other funds that have built long-term records by turning out consistently above-average performance within their investment category year after year after year. And because of the media's focus on each year's hot funds, many investors never hear about the funds that provide this kind of consistent performance. At Standard & Poor's, we identify funds that deliver consistent performance by analyzing absolute and risk-adjusted performance for each year over a three-year period. We give each fund a quantitative score ranging from 1 to 100, comprised of equal-weighted proportions of these two measures of historical return. Funds that score in the mid-second quartile or above are candidates for Standard & Poor's Fund Management Rating status. Identify disciplined, experienced management The Standard & Poor's Fund Management Rating research process considers consistency of performance, but as we recognize, quantitative performance analysis is not enough. We believe that both quantitative performance data and qualitative fund management analysis are needed to provide a true measure of investment fund excellence. Ratings Funds that earn the Standard & Poor's Fund Management Rating are classified AAA to A. These funds, in Standard & Poor's view, demonstrate an ability to provide above-average consistent performance, along with the ability to adhere to a set investment process. Management quality is a crucial element of consistent investment fund success. At Standard & Poor's we believe a strong management team, a clear investment philosophy and a well-defined investment process can have a significant impact on the consistency of a fund's performance. We believe that evaluating managers requires a hands-on approach, including extensive face-to-face interviews, performed by experienced investment fund analysts. In our view, it is only by understanding the minds behind the money that investors can increase their chances of selecting the most consistently performing funds. We believe that managers who have a clear philosophy and continually implement it through a disciplined process are more likely to be able to replicate their results. Incorporate quantitative data with qualitative research Thoroughly assessing management quality means examining issues such as: Organizational strength What is the organization's history and structure? What other companies does it own and how might they affect the management of the fund? Does the organization have a well-developed business strategy? Is there an overarching investment philosophy, investment process and strategy for managing risk? Fund management team What is the depth and stability of the fund management team? How many people support the fund manager and what is the reporting structure? What level of experience do team members have? How long have key people been managing the fund? How does the team generate and evaluate investment ideas? What research capabilities support the investment process? Fund management/style consistency What is the fund manager's experience, track record and philosophy? Has the manager run similar funds in the past at the same or different companies (especially if he or she has less than a three-year record at the current fund)? If so, what was the manager's previous track record? How well-defined is his or her investment process, including stock screening, portfolio construction and sector allocation? How does the philosophy of this fund fit with that of the fund management group? Has the manager stayed true to his or her stated style? How much risk has the manager taken to achieve the fund's returns? Is it consistent with the stated risk parameters? What resources are available, including people, systems and research? Does the fund manager have other responsibilities (i.e., managing other funds, serving on the fund sponsor's investment committee, marketing, etc.)? Portfolio construction What is the portfolio's benchmark? Are there constraints on sector weightings relative to the benchmark? What are the manager's guidelines on asset allocation and cash positions? How does the manager ensure that the portfolio remains consistent with his or her stated investment style? How do the managers feel about using derivatives or leverage? How concentrated do they prefer to keep the fund's portfolio? What are the manager's buy/sell disciplines? What are the portfolio manager's objectives for managing the portfolio's turnover and tax efficiency? Performance What major investment decisions were made over the past year and how have they worked out? What are the fund's current holdings and how have they changed recently? On what sectors and industries does the management team currently concentrate and how has that changed recently? What is the manager's explanation for periods of outperformance or underperformance? There are no right or wrong answers to these questions. However, when a fund is managed with a consistent philosophy, style and portfolio construction over time, we believe it is more likely to provide above-average relative performance in the future. Monitor funds on a continuous basis Past performance by itself may not be a predictor of future results. And disciplined management and investment processes are important, but only if they can deliver consistent performance. Standard & Poor's Fund Management Rating research is unique in that it considers both kinds of information. It identifies the premier funds in each asset class - approximately 20% of funds in each universe - that have met our rigorous standards for both performance and management expertise. By emphasizing the important link between management quality and consistency of performance, we can deliver more informed, stable conclusions than performance data alone allows. We've discussed the importance of concentrating both on consistent performance and management quality. While these factors don't change as rapidly as quarter-by-quarter performance results, investors and investment professionals must still be armed with timely, relevant updates and analyses to make informed decisions on a continuous basis. Because of our focus on fundamentals, Standard & Poor's Fund Management Rating funds tend to merit their status longer than funds reflecting typical performance-based evaluations. We monitor the funds that have achieved the Standard & Poor's Fund Management Rating status through a comprehensive process that tracks fund performance, management and portfolio holdings. A new standard for investment fund research We look for long-term consistency in each of these areas as well as a demonstrated commitment to each fund's stated investment approach. Our process is not mechanically driven by performance statistics. Rather, it incorporates a more thorough understanding of manager philosophy, objectives and process. Because we constantly monitor these factors, we are able to alert our users to any significant changes in fund management, style or portfolio emphasis. If Standard & Poor's changes its opinion on a fund, it is because Standard & Poor's has determined that there has been a fundamental change in the fund or its management, not simply a shift in short-term performance. How to tell when a good fund turns bad Almost all investors and investment professionals have had this experience: After conducting exhaustive research, you select a high-quality investment fund that meets a specific set of investment objectives, asset allocation needs and risk tolerance criteria. The fund's performance then declines. Is it a good fund that's experiencing temporary difficulties? Or have there been fundamental changes which indicate that the fund will no longer perform at its previous level of excellence? A short period of underperformance doesn't always indicate the fund manager has lost his or her touch. It may, in fact, simply demonstrate that the fund manager remains true to the fund's style regardless of short-term changes in market emphasis. Standard & Poor's believes that several types of events - in conjunction with poor performance - may merit an in-depth review of a fund. These events include: A change in fund management company ownership A new portfolio manager A significant shift in asset allocation Substantial drift in investment style Sustained underperformance When our regular monitoring process alerts us to these types of changes, we typically contact management to gain a better understanding of what is happening.