Morningstar Ups the Ante in the Mutual Fund Ratings Game

Trying to find the perfect mutual fund for your personal situation can be a bit like attempting to find a polar bear in a snowstorm. To help investors, research firms such as Morningstar Inc. and others contribute over a dozen rating systems to make fund comparisons more intuitive. While methodologies may differ tremendously from firm to firm, ultimately the rating firms must continually modify their classifications, seeking to combine past performance data with future predictions to suit changing investor needs.

Though many investors are unaware, the approach to buying and selling mutual funds has endured a recent revamp; Morningstar rolled out its new forward-thinking mutual fund “analyst rating” late last year. Alongside the firm’s popular one-to-five star rating system, which will continue to be offered investors, Morningstar’s new ‘game-changer’ boldly professes to illustrate which funds will outshine others going forward.

Morningstar executives explain that the analyst ratings are intended to manage misuse and fill the void left by star ratings. The trouble with the long-standing star-oriented structure is its inability to make future performance projections. In the old system, stars were awarded on a curve for risk-adjusted returns within a fund’s peer group, with the top 10% receiving five stars, the next 22% earning four stars and so on.

However, investors have come to treat the star system as an endorsement, which has led to misuse of the system.

“One of the things that was frustrating was that people would see a star rating on a quality fund go down and say ‘Morningstar is giving up on this fund,” says head of fund research, Don Phillips. “In many cases, we were still believing in the management team and think there’s every reason investors should stick with it.”

The new ratings serve as a formal opinion of which funds might realistically perform well in the future. The bottom line is the new Morningstar system adds the company’s proprietary analyst ratings, resulting in an approach with the future in mind.

The new ratings are: gold, silver, bronze, neutral and negative are based on what the leading investment research firm calls the “five pillars,” including: “process (investment strategy and execution), performance (results versus expectations over time), price (expense ratios), people (management skill, conviction and dedication to the fund) and parent (stewardship grade – a Morningstar measure of the quality of governance). After each pillar is evaluated, a committee determines the official rating.

The new designations are expected to alter the fund selection process substantially, as investors no longer must to settle for ‘good’ when ‘better,’ is not only available, but spotlighted.

So far, 350 funds have received new ratings, with 155 winding up with a “gold” rating an “improbably large number.” An additional 109 earned silver and a mere eight funds dubbed negative.

However, it is important to keep in mind that according to dailyfinance.com, most Wall Street firms bestow considerably more ‘buy’ recommendations than ‘sell.’

At present, it is too early to determine whether any recognizable biases will persist. The company intends to rate as many as 1,500 funds, which will lead to a more equally distributed rating spectrum.

Advisors warn that though Morningstar’s new analyst ratings are predictive by nature, one may want to stop and think before building a portfolio purely out of gold funds.

For example, the company’s past analyst picks have performed with a mixed record. While two-thirds of actively managed funds dubbed ‘gold’ have surpassed their category peers, less than half have beaten their index benchmarks, Morningstar says.

“If everything is in place for a fund… to succeed… then a run of poor performance alone should not make you think it will be a bad fund in the future,” said Karen Dolan, Morningstar’s director of fund analysis. She went further, explaining that a neutral rating is not a ‘sell’ indicator; even if not the best, it doesn’t require anyone to immediately sell the investment.

When the old system and the new agree is obviously a positive point. For instance, Vanguard Energy earns top ratings for both classification structures. This is largely due to enduring results and promising prospects for companies including Chesapeake Energy, Suncor and Ultra Petroleum.

What is more difficult however, is the question of how to evaluate funds that perform well in one scheme and poorly in another, such as the Clipper Fund. Earning only a single star based on its unsuccessful run, Morningstar still gave the fund a gold rating. Thus, the analysts at Morningstar are obviously relying on fund managers Chris Davis and Ken Feinberg to improve their lackluster results going forward.

“We still believe in the star rating or we wouldn’t keep it out there,” Dolan added. “…but [the new configuration] is subjective and it allows you to make sure that you’re not just looking at performance.

Still, the Morningstar team does not anticipate the new offering to be the only tool investors turn to.

“It’s not a complete solution,” Dolan said. “It just gives you a signal from us, saying this is our view on the fund’s ability. It doesn’t take your needs into consideration and it doesn’t suggest an asset allocation, but if you know what you’re looking for, it should help you make a decision you’re comfortable with.”

As with any evaluation method, Morningstar’s new fund rating system will require time to assess its success. Until you’re certain and comfortable with the ratings the investment’s results, it is recommended to take caution and use an assortment of analysis techniques. Ultimately, only time will tell if the new and improved rating method will truly benefit investors.

 

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