Morningstar's new forward-looking rating scale for mutual funds is sure to have a significant impact on the research done by financial advisors.
For many years, Morningstar has rated mutual funds from one to five stars, and these rankings have been the accepted standard. But those ratings look backward, comparing a fund's past record with the performances of its peers.
The stars didn't do a great job of predicting the future, acknowledges Don Phillips, president of fund research at Morningstar. He notes that a Morningstar study found that a fund's costs were a better predictor than its own star rating. The company did find, however, that costs and the star rating together proved to be a better predictor than costs alone.
The new forward-rating system is intended to go far beyond costs and past performance to be an even better predictor than anything Morningstar has had before, Phillips says.
GOLD, SILVER AND BRONZE
The new system is based on analysts' beliefs about a fund's ability to outperform its peer group or a relevant benchmark. If a fund receives a rating of gold, silver or bronze, Morningstar's analysts are expecting the fund to outperform over a five-year period. A neutral rating takes no position, while a negative rating indicates likely underperformance.
The ratings (see chart on the next page for additional detail) measure funds against five criteria, or "pillars" in Morningstar's terminology.
These pillars are:
Process: What is the fund's strategy, and does management have a competitive advantage that will enable it to execute the process well and consistently over time?
Performance: Is the fund's performance pattern logical given its process? Has the fund earned its keep with strong risk-adjusted returns over relevant time periods?
People: What is Morningstar's assessment of the manager's talent, tenure and resources?
Parent: What priorities prevail at the mutual fund - stewardship or salesmanship?
Price: Is the fund a good value proposition compared with similar funds sold through similar channels?
In this last category, costs are compared only with those in similar sales channels - advisor-sold funds, for instance, would be compared only with other advisor-sold funds. Morningstar's goal is to be agnostic about distribution channels, Phillips says.
The pillars go deeper than the simple descriptions suggest. For example, the people pillar examines whether a fund manager has significant investments of his or her own money in the fund.
Before assigning an overall rating, Morningstar assesses every pillar of a fund, giving a positive, neutral or negative rating for each. The five pillars are a framework rather than a formula. You can't just look at the five pillars and use arithmetic to derive the overall rating of the fund, Phillips says.
Morningstar, which launched the new rating system with 349 mutual funds in November, has now rated about 700 mutual funds, and hopes to rate 1,200 to 1,500 funds by the end of the year. Because Morningstar selected the initial funds based on analysts' picks, gold and silver were the most common results.
As of the end of the first quarter, funds rated gold and silver each accounted for 24% of the total, while funds rated bronze and neutral each accounted for about 22%. About 7.5% of the funds received a negative rating.
The forward-looking ratings sometimes produce significant differences from the backward-looking star system, which Morningstar does not plan to discontinue. For example, the Clipper Fund (CFIMX) has a two-star rating, having underperformed its peer group by 2.21% annually over the past decade. Yet its new overall Morningstar rating is gold, with all pillars positive except performance, which is rated negative. The gold rating has not yet been indicative of a turnaround, with the fund underperforming by 3.46% through the first quarter of the year.
BENEFITS FOR ADVISORS
For advisors, the benefit of the new system is that they can gain the expertise of 30 impartial and well-trained analysts with access to fund managers, which has made Morningstar the gold standard of mutual fund resesarch. That analysis is supposed to add to - but not replace - the due diligence of an advisor. "The suitability decision still rests with the advisor," Phillips says.
Through its ratings, Morningstar does not take a stance on the overall direction of the markets or a market segment. What it is predicting is whether a highly rated fund in one category is likely to best a fund with a negative rating in the same category. That means it is not a tool for tactically allocating assets or for deciding how much style or industry tilt a portfolio should have.
For advisors, the usefulness of the new system is in selecting funds within a client's portfolio. For example, in selecting a large-cap blend domestic equity fund, an advisor may be considering three choices: Fidelity Growth and Income (FGIKX), Oakmark I (OAKMX) and Vanguard Total Stock Market Index (VTSMX). The funds have four- or three-star ratings, showing they have bested their peers recently.
Under the new system, only the Oakmark and Vanguard funds are predicted to outperform; they both received gold ratings. The Oakmark fund received positive ratings on all pillars except price, where its 1.04% expense ratio earned negative marks. The Vanguard fund earned positive pillar ratings across the board. Morningstar gave Fidelity Growth and Income a neutral rating, due to neutral listings on the process, performance and parent pillars.
In this hypothetical case, the selection might come down to a philosophy of investing in a more expensive actively managed fund or a less expensive passive fund. If an advisor were to choose the Fidelity fund, he or she would be discounting the new research, and would have his or her own rationale for the decision.
Building a client portfolio of mostly gold- and silver-rated funds could add credibility since an advisor could tell a client that he or she had built a diversified portfolio consisting of mutual funds having low costs, strong fund families and talented, long-tenured managers. In addition, these funds' processes are seen providing competitive advantages, which is expected to translate into performances besting their peers on a risk-adjusted basis.
Another benefit to an advisor is that if a fund or portfolio does poorly, there may be some safety in being able to share the blame with Morningstar and its expert analysts.
Of course, in some cases, a client could use the new ratings against an advisor. Anyone with an Internet connection can see these ratings.
If, for example, an advisor selects the Legg Mason Capital Management Growth Trust Class C (LMGTX), he or she may have some explaining to do. Under the old rating system, it would be easy to note that the one-star rating is historic and not indicative of future performance. Indeed, this fund has actually bested its peers over the past three years, in spite of dismal performance over longer periods of time. But this fund now has a negative forward-looking rating and the five pillars all receive negative or neutral ratings.
Though Morningstar notes the fund manager, Robert Hagstrom, is a student of Warren Buffett, it gives him a negative rating, implying that he might not have been one of Buffett's star pupils. It could be rather uncomfortable for an advisor to explain to a client why this fund was chosen, especially if it performs poorly in the future, as projected.
Advisors can also benefit by keeping track of when a fund's rating is changed. If, for example, a fund's rating is downgraded, an advisor can study Morningstar's reasoning and consider whether this changes his or her assessment of the fund's value and asset allocation in a portfolio.
GRADING THE RATINGS
Will these new forward-looking ratings have staying power and maybe even replace the five-star system? Morningstar will begin assessing the performance of its new system in three years, Phillips says, and should have good data in five years.
The firm is optimistic that the new system will be more accurate than relying on costs alone. A Morningstar study found that a fund's scores on governance and people have been predictive of performance, meaning all five pillars should be better than the single pillar - price - that examines a fund's costs versus its peers.
Michael Kitces, a CFP who is publisher of the Kitces Report website and newsletter, says he's a fan of the new ratings and thinks they add to the overall picture of what funds are doing. This can be helpful to advisors and clients who don't have the time or inclination to do the level of in-depth due diligence that Morningstar has conducted.
"I see this as a part of the overall rise of a trend for more qualitative assessments of mutual funds to complement the purely quantitative measures," Kitces says.
As Morningstar sees it, the new rating system's main value is a "contribution to the debate" on selecting funds, Phillips says.
Allan S. Roth, a Financial Planning contributing writer, is founder of the planning firm Wealth Logic in Colorado Springs, Colo. He also writes the Irrational Investor column for CBS MoneyWatch.com and is an adjunct faculty member at the University of Denver.
Morningstar's New Rating Scale
Gold: Best-of-breed fund that distinguishes itself across the five pillars and has garnered the analysts' highest level of conviction.
Silver: Fund with advantages that outweigh the disadvantages across the five pillars and with sufficient level of analyst conviction to warrant a positive rating.
Bronze: Fund with notable advantages across several, but perhaps not all, of the five pillars - strengths that give the analysts a high level of conviction.
Neutral: Fund that isn't likely to deliver standout returns, but also isn't likely to significantly underperform, according to the analysts.
Negative: Fund that has at least one flaw that is likely to significantly hamper future performance and that is considered by analysts an inferior offering to its peers.