PACRA Introduces Changes in its Mutual Fund Rating Methodology

PACRA has pioneered the introduction of rating of mutual funds and asset managers in Pakistan. The first such rating was carried out in 1999. Since then, the rating universe for asset managers as well as for mutual funds has continued to grow. Till now, these ratings were sought on a purely voluntary basis. However, as per the directive of Securities & Exchange Commission of Pakistan issued on 19 th August 2005, it has now been made mandatory for asset managers as well as for individual mutual funds to obtain rating and subject themselves to a continuous review of the rating process.

PACRA's asset manager rating seeks to determine the professional capacity of asset managers. It, therefore, provides a measure of the asset managers’ capacity to master the risk inherent in asset management. The rating methodology represents a systematic framework to assess the quality of business structure, independence, control and communication systems, investment process and risk management. PACRA’s detailed Asset Manager Rating Methodology is available separately and can also be seen on our Website: www.pacra.com.

PACRA's performance rating of mutual funds, while focusing mainly on quantitative aspect of performance has hitherto treated all mutual funds as one peer group for purposes of evaluating relative performance. However, this matter has been under PACRA's review for the last six months. The review has included a detailed analysis of rating methodologies of the leading global rating agencies for determining the best international practices. The other important objective of the review was to ensure that PACRA's rating offers a meaningful and usable tool to potential investors in guiding their investment decisions. It was also realized that an essential ingredient of the rating process should be to take into account the risk return perception of different classes of investors.

Every mutual fund investor has a distinct set of investment objectives and preferences. It is, therefore, difficult to capture these preferences in a single yardstick for guiding investment decisions. PACRA revised Fund Rating (referred to as PACRA star rating) attempts to address this investor need. The rating is a purely quantitative measure, avoiding any biases. It is based on historical returns of a fund relative to other funds in similar category. PACRA has defined different fund categories – each having distinct characteristics – and ratings of funds in a particular category are comparable. The rating methodology is designed in a manner that the star rating of a fund conveys a sense of how skillfully the fund has been managed; that is, the relative star ratings of two funds in a category should be affected more by manager skill than by market circumstances or events that lie beyond the fund managers’ control. While the fund rating reflects the actual recorded performance, the likelihood of sustainability of performance - or improvement - can be judged from the rating of the manager of that fund.

PACRA, after a detailed evaluation of mutual funds in Pakistan, has identified the following categories for purposes of distinct and separate peer groups:

Income Fund: a fund that primarily invests in debt securities including money market instruments.

Equity Fund: a fund that primarily invests in equity securities.

Balanced Fund: a fund that carries a reasonable mix of equity and debt securities.

Islamic Fund: a fund that invests in Shariah compliant instruments only.

PACRA considers both absolute and risk-adjusted performance. Absolute return refers to the appreciation or depreciation that a fund has achieved over a period of time and effectively this is what an investor takes home at the end. However, at the same time, the level of risk (extent of variability) that is involved with those returns is also important. Risk-adjusted return shows the trade-off investors make between risk and return. A combination of both absolute and risk adjusted performance is likely to provide investors a better measure to gauge historical performance of different funds. Thus, the total return on the fund during the given period as well as the risk-adjusted return is calculated. The overall quantitative score is then worked out and ratings are assigned according to the following distribution: