The initial criteria for inclusion on the Hero Funds list are derived from the Sesame Research Panel.  From the recent Sesame listing of 346 funds, the best 65 ideas will form the core Hero Funds list.  Another 10 wild card funds approved by TQ Invest's Investment Committee will also be included.  The 10 wild cards allow for new funds especially but also gives the Investment Committee the power to sign off any other fund that may not otherwise have made it on to the list.  For example, a lead fund manager might leave and hence the fund could lose its ratings but the Chief Investment Officer might operate a team based approach which meant the fund was still in good hands.  Also, thematic funds often arrive on masse to the market and we might want to consider one of these for inclusion too.  All IMA defined sectors will be considered for the list.

Sesame Research Criteria includes the following:

1.1          Quantitative Analysis
The primary quantitative screen for mutual investment funds (unit trusts, OEICs) is constructed according to a mixture of absolute (fixed) and comparative criteria and based on data submitted by providers to Lipper Hindsight.  The purpose of the screen is used as a source of ‘best ideas' to identify funds that should be investigated in further detail.

1.2          Fixed Criteria
Sesame's normal fixed criteria are as follows:

• Select established funds that are greater than £10m in size and have a performance track record of five or more years.
• Select funds that have a minimum investment that is appropriate for most private investors. For this review, this is set at £5,000.
• Select funds with an annual management charge of less than 1.5%p.a. (this ceiling may be raised in high growth sectors).

1.3          Comparative Criteria
Comparative measurements of individual funds are calculated in terms of standard deviations relative to the peer group average (so called ‘z-scores').  The peer group generally refers to the relevant IMA sector.

To be considered in further detail funds must generally meet the following two criteria:

• Funds whose frequency of outperformance (over rolling 12-month periods) within a 5-year timeframe is at least ½ standard deviation above the peer group average.
• Funds that have achieved a comparatively good return without taking excessive risk as indicated by comparative (z-score) five-year volatility being no greater than comparative performance.

1.4          Qualitative Analysis
The background information for the qualitative analysis is provided mainly by the use of questionnaires completed directly by the provider, although research material is also gleaned from other sources.  These questionnaires are designed to provide information covering:

• History and current business of the management company
• General investment philosophy of the management company
• Fund manager history
• Investment approach
• Recent portfolio changes and comments
• Other more specific queries

Sesame is looking to select funds that can display the potential for consistent outperformance of their peer group. Amongst other things they are looking for evidence that:

• Performance is due to process or talent rather than luck and hence has the potential to be repeated.
• The fund manager has suitable experience and/or talent or that the investment house has a strong investment process for a team approach.
• There is suitable back-up and resource to the fund manager, including a designated person who would take over the management of the fund in unforeseen circumstances.

TQ Invest additional research criteria includes the following:

Each fund reviewed will achieve a ratings score, performance score and ratios score.  The funds with the highest overall scores will be included in the draft Heroes List.  The funds availability on Cofunds and Fundsnetwork platforms and maximum initial charge discount availability will also need to be considered for final inclusion to the list.

2.1          Ratings Score

Each fund reviewed may achieve an independent rating from Financial Express (Crown), Old Broad Street Research (OBSR) and Standard & Poor's (S&P).

Crown Ratings are a quant-based ratings system designed to highlight funds that have had superior, consistent performance in relation to risk, relative to their peer groups, the fund sectors as defined by the IMA and the ABI.  Crown Ratings are compiled using three key measurements of a fund's performance - alpha, volatility and consistency - with each rated fund receiving 1, 2 or 3 crowns.

OBSR provides Fund Ratings as an independent mark of quality.  Based on a proven research process where qualitative research is supported by quantitative analysis, OBSR ratings are evidence that a fund is, for its type, consistently producing the returns it sets out to deliver, and will continue to do so.  Once the due diligence process has been concluded, a fund may be considered for an OBSR Fund Rating.  Funds are then presented to the OBSR Fund Rating Committee for consideration.  The ratings range from A to AAA and are designed to be an independent mark of quality but also a clear indication of OBSR's conviction in a manager's ability to meet or exceed a fund's objectives compared to other funds of a similar type.

S&P's fund ratings are based on an analysis of quantitative and qualitative factors.  The quantitative analysis looks at historical performance and how consistent it is.  The qualitative analysis includes in-depth personal interviews to make an informed assessment of the fund company, portfolio manager, investment team and individual aspects of the funds.  Less than 20% of funds in each asset class are even accepted into the multi-stage rating process.  Funds are rated from A to AAA with A considered high quality, AA very high quality and AAA exceptional quality.

2.2          Performance Score

Fund performance on an annual discrete basis over the last 5 years will be reviewed.  Funds will score more highly if they achieve above average sector performance in a discrete calendar year.  Fund performance over different parts of an economic cycle can be analysed using a five year time frame.

2.3          Ratios Score

The following ratios will be analysed:

Alpha - a measure of a fund's over or under performance by comparison to its benchmark.  A high Alpha indicates the extra value that the manager's activities have contributed.

Beta - a statistical estimate of a fund's volatility by comparison to that of its benchmark.  A low Beta indicates the fund is less volatile than its benchmark.

Information Ratio - assesses the degree to which a manager uses skill and knowledge to enhance returns, this is a versatile and useful risk-adjusted measure of actively managed fund performance.  An IR above 0.5 is considered good.

Jensen's Alpha - a risk-adjusted measure used to gauge the extent to which a manager has added value to the returns that could have been expected from a benchmark portfolio with the same degree of sensitivity to movements in the market (Beta).

Sharpe - a commonly-used measure which calculates the level of a fund's return over and above the return of a notional risk-free investment, such as cash or Government bonds.  As the ratio increases, so does the risk-adjusted performance.

Treynor - another risk adjusted performance measure.  It looks at excess return for each unit of systemic risk (the volatility, inherent in the market that cannot be diversified).  Also known as the Volatility to Reward ratio, Treynor is useful in comparing funds that invest in similar market sectors and achieve similar returns.

Volatility - shows how widely a range of returns varied from the fund's average return over a particular period.

To find out more about the risk ratings of our Hero Funds click here.