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It is no secret that IMA sectors are subject to criticism from time to time and they have been generating a lot of attention recently. The last few months have seen the IMA receive an influx of suggestions to change sector definitions, close down sectors and create new sectors.

First and foremost, we need to remember the sectors have been designed to help investors find the best funds to meet their investment objectives and to compare how well their fund is performing against similar funds. Bearing this in mind, if we were to act on every suggestion made, we would see the sectors changing constantly and funds moving sectors regularly. It is fair to say this would cause a lot of confusion for consumers and advisers and performance records would lose their value. Now is as good a time as any to remember why there is a sector classification system, how it works and why, in fact, the one we use now is the most plausible.

Classification

IMA maintains a system for classifying its 2000-plus investment funds by placing them into one of its 31 sectors and grouping similar funds together. The sectors are split principally into two categories: those designed to provide “income” and those designed to provide “growth”. The funds are then classified into a variety of categories to keep funds with similar investment objectives or asset allocation together – for example Money Market, North America, Active Managed and UK Corporate Bond. Each sector is made up of funds investing in similar assets, in the same stock market sectors or in the same geographical region. In addition, there is a capital protection category, including for example the Protected/Guaranteed sector. The Specialist is the exception to this rule. The Specialist sector acts as a "catch all" sector, and includes groups of funds which are too small to justify a full sector.

The IMA sector classification system is overseen by the Performance Category Review Committee (PCRC), which is made up of representatives of a cross-section of IMA member companies and the major fund data suppliers. The detail of the committee’s work in progress remains confidential until it is ready to be shared with the membership at large.

The market for funds is not static. Investment tastes change, often in response to market developments, and such changes need to be reflected within the classification system. The PCRC reviews the classification system regularly, ensuring the definitions are clear cut, removing sectors where there are too few funds to permit fair comparisons to be made, and splitting out new sectors in circumstances where new funds have emerged in sufficient numbers and where their separate identification would be useful to consumers.

The recent creation of the Absolute Return sector illustrates how the PCRC considered a change in investment tastes. The Absolute Return sector was created to group together funds managed with the aim of delivering absolute – more than zero – returns in any market conditions. This is highly appropriate given the current climate. Absolute returns funds offer the prospect of additional portfolio diversification for consumers at a time of market uncertainty.

This sector differs from traditional sectors, as it is not asset-based. The funds all share the same philosophy and aims rather than types of assets. Even though this sector is not appropriate for performance comparisons, at least at the outset, it groups funds which aim to provide absolute returns and investors will be able to make other comparisons when choosing which absolute return fund to choose.

Property sector

Property funds currently sit in the Specialist sector and there have been ongoing calls to give property funds their own sector. IMA had a property sector for some years, but this was closed in 2003/04 as it had shrunk to three funds. Property funds were last formally reviewed in 2004, but creating a property sector was rejected due to there still not being enough homogenous funds. The current mix includes funds investing in property shares versus direct property, with markets ranging from UK, Europe and Asia to global property funds.

A new review looking into the creation of a property sector is on the IMA agenda for 2008 as a result of the increase in the number of funds and assets under management since the last review. Depending on the outcome of the review, consultation may take place in the latter half of 2008. There is no set date for finalising a decision.

UK Zeros sector

The UK Zeros sector currently holds six funds. It has been flagged up for review given the small number of funds populating the sector.

If it is to be removed, the IMA will have to contact groups who have funds in the sector so they are aware of the intended changes. This may lead to requests to manage the sector closure for timing reasons as the general marketing of the funds will have to change due to them having to move sector.

The PCRC has set up an independent system to monitor individual funds’ adherence to the sector definitions. Funds are monitored monthly against the criteria set by the appropriate sector definition, for example against maximum or minimum percentage of an asset class.

To facilitate this, Lipper collects portfolio holdings data from management groups and analyses individual funds' compliance with sector definitions.

For groups that do not submit data or breach sector guidelines, the IMA has a disciplinary procedure in place:

● If they intend to comply with the sector in which they reside then they have a three month window from the date of being informed that they are in breach to achieve that. They also have to make a commitment to long term adherence.

● If they do not intend to comply or there is no response within one month of them being notified, then the fund should be removed from the sector as soon as possible.

As with all sector issues it is important to note that many issues may need to be treated on a case by case basis. We should also remember that monitoring works; once being picked up on a breach, most funds come back into line with sector requirements.

IMA is aware of previous issues regarding the UK Equity Income sector. However, new accounting conventions had to be dealt with before the definition could be changed. The definition was amended with effect from 1 January 2008, with clear guidelines laid out as to how yields must be calculated for sector compliance purposes. Firms have a choice in the way in which they present their fund accounts, but they do not have a choice as regards valuation for sector compliance purposes.

The calculation allows funds to be compared like for like and offers a calculation that is based on historical figures. With a definition based on clear cut parameters for calculating the yield IMA will be able to monitor the sector accurately. The funds have up to one year to comply with the amended definition, reflecting the reality that as the yield calculation is historical, looking back over 12 months, the funds may take up to 12 months to come into line with the definition as from the beginning of 2008.

It is fair to say the current sector classification system is not perfect, but it is also fair to say that IMA has taken on board many suggestions to improve sectors. It is important to understand that not all of the 2000 plus funds will be completely happy with the sector they are in and it is not practical to change the parameters of a sector based on what the minority would like. When it comes to making changes to the sectors, we need to consider all factors and then make a decision – this takes time, careful consideration and expert input and this is why the IMA cannot make changes overnight.

Jane Lowe is director of markets at the IMA

Main points:

- It is not possible for IMA sectors to change to fall in line with every suggestion made. For the sake of consistency, investors need clear rules that stay the same for extended periods of time.

- The sectors are split principally into two categories: those designed to provide “income” and those designed to provide “growth”. The funds are then classified into a variety of categories to keep funds with similar investment objectives or asset allocation together

- The sector classification system is overseen by the Performance Category Review Committee (PCRC), which makes decisions about sectors and also oversee the policing process.

- The creation of the Absolute Return sector is the latest new group created, reflecting the PCRC's ability to be flexible and keep in touch with industry trends.