MORNINGSTAR STAR-RATING SYSTEM CALCULATION PROCEDURES

1005 based upon an agregation of the three-, five-, and 10-year risk-adjusted return for funds with 10 year risk-adjusted return for funds with 10 years or more of return history, three- and five- year risk-adjusted returns for funds with five to less than 10 years of return data, and three- year risk-adjusted returns for funds with five to less than five years of return data. To calculate the risk-adjusted return for the fund by adjusting returns for expenses and other costs automatically taken out of the fund, and then by adjusting for front-end and deferred loads. Next, εorningstar calculates a ‗‗εorningstar return‘‘ in which the expense-and load-adjusted excess is return divided by the higher of two variables: the excess average return of the fund category or the average 90-day T-bill rate; 153 Morningstar then calculates a Morningstar risk measure, which is calculated differently from traditional risk measures, such as beta and standard deviation that both see greater-than and less-than-expected returns as added volatility. Morningstar believes that most investors greatest fear is losing money, which Morningstar defines as underperforming the risk-free rate of return an investor can earn from the 90-day Treasury bill. Hence, their risk measure only focuses on downside risk. 154 To calculate risk, Morningstar plots monthly returns in relation to T-bill returns, adds up the amounts by which the fund trails the T-bill return each month, and then divides that total by the time horizons total number of months. This number, the average monthly underperformance statistic, is then compared with those of other funds in the same broad investment category to assign the risk scores. The resultant Morningstar risk score expresses how risky the fund is relative to the average fund in its category. To calculate a funds summary star rating, Morningstar calculates the three-, five-, and 10- year Morningstar return and risk. For each time horizon, the Morningstar calculates its raw rating by subtracting the Morningstar risk score from the Morningstar return score. Then the three numbers one for each time horizon are then given subjective weights. The three-year number receives a 20 weighting, the five-year a 30 weighting, and the 10-year a 50 weighting. In the case of young funds funds with three to less than five years of return data, the three-year number receives a 100 weighting; in the case of middle-aged funds funds with five to less than 10 years of return data, the three-year number receives a 40 weighting and the five-year number receives a 60 weighting. With these weights, Morningstar calculates the weighted average of the numbers. See Figure 1 The resulting number is then plotted along a bell curve to determine the funds star rating. If the fund scores in the top 10 of its broad investment category, it receives a rating of five stars; if the fund falls in the next 22.5, it receives four stars; if it falls in the middle 35, it receives three stars; if it lies in the next 22.5, the fund receives two stars, and if it is in the bottom 10, it receives one star. 155 Figure 1: Distribution of Star Ratings Within a Category in the Morningstar Rating System Source: BENZ Christina, TERESA Peter, KINNEL Russel, Morningstar Guide to Mutual Funds, John Wiley and Sons, New Jersey, Jan 2003, p.32 bond and taxable bond. But Turkish pension mutual funds differ from any aspects asset classes, investment strategies, size etc. from US mutual funds. Therefore in the study pension mutual funds category numbers are enlarged. 153 BLAKE R. Christopher, MOREY Matthew R., Morningstar Ratings and Mutual Fund Performance, Journal of Financial and Quantative Analysis, Vol.35, No.3, September 2000, p.457 154 Focusing only on downside risk is neither unique to Morningstar nor new; it was explored by Markowitz 1959 and incorporated into an asset-pricing model by Bawa and Lindenberg 1977. 155 BLAKE R. Christopher, MOREY Matthew R., a.g.e., p.458 1006

3. STUDY FRAMEWORK

According to the PMC Pension Monitoring Center and CMB Capital Market Board Turkish pension mutual funds are grouped into five categories. Therefore in the study the pension mutual funds are grouped into five categories according to the asset types as follows; 1 Flexible-Balanced Funds: Pension mutual funds, asset allocation of which are not pre specified, are determined by a portfolio manager in accordance with the market conditions and main limits laid down at the relevant regulation. This funds portfolio mainly consists of Gov‘t Bonds and Bills and can be supported by trading shares listed at ISE Istanbul Stock Exchange, especially during the uptrend market periods. 2 Stock Funds: Pension mutual funds include minimum 80 of stocks in their portfolios, the return trend of funds are highly corellated with ISE . 3 Gov‟t Bonds and Bills Funds: Pension mutual funds include minimum 80 of Gov‘t Bonds and Bills in their portfolios. 4 International-Currency Indexed Funds: Pension mutual funds which carry minimum 80 of foreign instruments, with the returns of Euro and USD. 5 Liquid Funds: Pension mutual funds portfolio consists of capital market instruments of high liquidity with a maximum maturity of 180 days, and the upper limit of weighted average maturity of the portfolio is 45 days. So in the study the number of 60 funds which are 13 Flexible-Balanced Funds, 8 Stock Funds, 11 Gov‘t Bonds and Bills Funds, 15 International-Currency Indexed Funds and 13 Liquid Funds are rated using Morningstar-star rating system during January 2004-December 2008 time period. 156 In order to understand the main aspects of the study we explain return and risk variables calculation as follows; a Return Data: Firstly pension mutual funds monthly return used in the study. The return of the pension fund calculated as below; 157 r p : Pension mutual funds return V t : Pension fund unit price at t month V t-1 : Pension fund unit price at preceding month Secondly we use 91 day Trasury bill rate 158 to calculate Morningstar return. As we know to calculate the risk-adjusted return for the fund by adjusting returns for expenses and other costs automatically taken out of the fund, and then by adjusting for front-end and deferred loads. Next, εorningstar calculates a ‗‗εorningstar return‘‘ in which the expense-and load- adjusted excess is return divided by the higher of two variables. 159 b Risk Data: Standard deviation is sometimes criticized as being an inadequate measure of risk because investors do not dislike variability per se. Rather, they dislike losses but are quite happy to receive unexpected gains. One way to meet this objection is to calculate a measure of downside variability, which takes account of losses but not of gains. For example, we could calculate a measure of average monthly underperformance as follows: 160 1 Count the number of months when the fund lost money or underperformed Treasury bills, that is, when excess returns were negative. 2 Sum these negative excess returns. 3 Divide the sum by the total number of months in the measurement period. 156 In the analyze period some pension firms are merged or bought by the local and international insurance firms. Therefore changed pension firmsfunds name updated according to CMB Capital Market Board of Turkey. 157 CPM Capital Market Board, h ttpμwww.spk.gov.trappsaylıkbultenindex.aspx 158 91 day T-bill rate of return obtained from ISE Istanbul Stock Exchange Bonds and Bills Market Data, http:www.imkb.gov.trveri.htm 159 In the study the average T-bill rate is bigger variable than the excess average return of the category. So we prefer to use the average 91-day T-bill rate. 160 SIεONS Katerina, ‗‗Risk-Adjusted Performance of εutual Funds‘‘, New England Economic Review, SeptemberOctober 1998, p.36 1007 Mormingstar use downside risk in Morningstar risk calculation and this final risk score expresses how risky the fund is relative to the average fund in its category. While downside risk may be a better reflection of in vestors‘ attitudes towards risk, empirical evidence suggests that the distinction between downside risk and the standard deviation is not as important as it seems because the two measures are highly correlated. Sharpe 161 1997 analyzed monthly standard deviations of excess returns and average monthly underperformance in a sample of 1,286 diversified equity funds in the three-year period between 1994 and 1996. He found a close relationship between these two measures, with a correlation coefficient of 0.932. Such a close correlation is not surprising, since monthly stock returns generally follow a symmetrical bell-shaped distribution. Therefore, stocks with larger downside deviations will also have larger standard deviations.

4. PENSION MUTUAL FUNDS WEIGHTED PERFORMANCE AND STAR-RATING RESULTS

The investment process of pension mutual funds is strategically important as well as the fund performance for beneficiaries, retirement corporations and regulatory authorities. The analyses of these data are an important clue for the potential number of beneficiaries and the effectiveness of pension mutual fund investments. 162 Especially performance evaluation is very important for mutual funds and pension mutual funds which are institutional investors, a lot of numerical indices are widely used in the literature such as Sharpe, Treynor, Jensen and recently Morningstar-star rating. See Table 1 In this study we use Morningstar-star rating system to conclude performance and rating results of 60 pension mutual funds in Turkey. So we calculate Morniningstar risk adjusted performance and rating results as follows; Table 1: Study Periods and Other Details Age of Fund Morningstar Risk-Adjusted Performance and Star Rating Period Based On Number of Funds Analysed 1 At least 3 years, but less than 5 100 3-year raw return. 60 2At least 5 years, but less than 10 40 3-year raw return, 60 5-year raw return. 60 3At least 10 years 20 3-year raw return, 30 5-year raw return, 50 10-year raw return. Non available data and funds Turkish pension mutual fund industry commenced on October 27, 2003 . So there isn‘t enough data for 10 year. 4.1 Pension Mutual Funds Weighted Performance and Rating Results of Three Year Weighted 100 Three-Year Raw Return We present performance and rating results of Turkish pension mutual funds. So the funds grouped into five categories and ratings weighted 100 three-year raw return. See Table 2 The pension mutual funds which are grouped into Flexible-Balanced Funds, the best performing five star fund is Anadolu Hayat Emek lilik A.Α. Flexible Income PεF whereas the worst performing one star fund is Koç Allianz Hayat ve Emeklilik A.Α. Flexible Growth PMF. Table 2: Flexible-Balanced Funds Rank Name of Fund 3 Year Raw Return × 100 Result Percent Rank Number of Stars 1 ANADOδU HAYAT EεEKδİδİK A.Α. FδEXIBδE INCOεE PMF - 0,08 - 0,08 2 ANADOδU HAYAT EεEKδİδİK A.Α. FδEXIBδE GROWTH PMF - 0,63 - 0,63 8 3 AVİVASA EεEKδİδİK VE HAYAT A.Α. FδEXIBδE PεF - 0,65 - 0,65 17 161 SHARPE William F., http:www.stanford.edu~wfsharpeartstarsstars7.htm 162 AδTINTAŞ Kadir εurat, The Risk-Based Management Performance Evaluation of Turkish Private Pension Funds: An Analysis For 2004-2006 Period, Anadolu University Journal of Social Sciences, Vol.8, No.1, 2008, p.85