Morningstar is definitely the de facto go to standard for mutual fund investors; for two decades their star system has dominated the psyche. They appear to be making a quite dramatic change with a new evaluation system which appears to be a bit more qualitative rather than purely quantitative. Let the jockeying begin.
- Investors familiar with Morningstar's 5-star system for rating mutual funds will soon see ratings based on an AAA scale as well. It's an addition to give investors a sense of a fund's prospects, rather than just its past performance.
- The company on Thursday announced plans to assign Analyst Ratings to supplement star ratings beginning this fall. It's an acknowledgment that star ratings aren't a good tool to predict a fund's future results, a frequent criticism from fund managers as well as financial advisers.
- Star ratings are based on quantitative measures of a fund's past performance. Those include investment returns measured against the performance of similar funds, and the level of risk the fund took to achieve those returns. The analyst ratings will assess qualitative factors, such as judgments by Morningstar analysts of the strengths of a fund's managers and parent company, and whether they have a well-designed system to select investments.
- The star ratings are an achievement test, Phillips said. We view these new ratings as more of an aptitude test.
- Morningstar has assigned star ratings for more than two decades, and advertisements frequently tout those mutual funds with 4- and 5-star ratings. Such high ratings can entice investors to choose a fund that has enjoyed recently strong performance, compared with one that's been subpar. But a run of strong results can often be fleeting. All too often, the stock or bond picks that produced standout performance eventually drag on returns when the market shifts and those investments fall out of favor. That can lead to disappointing returns for those who invested in the fund too late, and turn a 5-star fund into a 4-star fund, or lower.
- On the flip side, historically strong-performing funds backed by solid managers can end up losing a star or two after a bad stretch of performance. But such funds often come back, rewarding investors who stuck with them.We want to give people some conviction to stay with the quality fund, Phillips said.
- Like the star ratings, the new system will use a five-level scale. Top-rung AAA funds are those Morningstar believes are in best position to deliver strong returns. AA and A funds are seen as less likely to do well, but are still considered to have positive ratings. Neutral ratings will be assigned to funds that aren't likely to deliver standout returns, either for the better or worse. A negative rating signifies a fund that Morningstar considers inferior.
- The ratings will be based on five factors: quality of the fund manager; quality of the investment process; quality of the fund's parent company; evaluation of long-term returns; and evaluation of the expenses the fund charges. Investors researching a fund on Morningstar's web site will see the fund's analyst rating above its star rating.
- Morningstar plans to assign analyst ratings to as many as 200 funds beginning in October, starting with funds that draw the most investor interest and assets. Over the next year, Morningstar hopes to rate more than 1,500 funds, holding more than 80 percent of fund industry assets.
- The analyst ratings will be assigned to funds that are new and old. That differs from the star ratings, which Morningstar assigns only to funds with performance records of at least three years.