Making a Clear Distinction Between Morningstar’s Dual Fund Rating Systems

Morningstar

Recently, I was asked by a beginning fund investor to explain why Morningstar has two “ratings” on mutual funds, and which one should she use.  She made reference to an article [“Flummoxed by Our Ratings? Here’s What You Need to Know,”] on Morningstar’s website written by Russell Kinnel, director of manager research for Morningstar.

The posting purports to explain how the Star Rating and Analyst Rating work. Unfortunately, I found the content, which is a transcript of Morningstar’s Christine Benz’s interview with Kinnel, somewhat confusing. Kinnel’s explanations are filled with numerous “I-thinks” and “maybes,” as well as other rather subjective language, which, understandably, confused my inquirer.

Nevertheless, buried in the last paragraph of the interview transcript is Kinnel’s conclusion that “… the analyst rating, I think, is maybe a better signal for investors …” By using the word “signal,” I assume he means a “green light.”

If I were Kinnel, here’s what I would do: Without any intended malice, I would go on record as saying that as of November 2011, the date Morningstar launched its new Analyst Rating evaluations, the star ratings have become irrelevant. By comparison, Morningstar’s analyst ratings represent a breadth and depth of quantitative and qualitative fund investment research that is unmatched in the financial community.

So here’s my take based on an objective comparative analysis of Morningstar’s Star and Analyst rating methodologies. You, the reader, can decide which approach serves your best interests.

The Morningstar STAR RATING uses a number of stars to rate the investment quality of a mutual fund on a scale of 1 to 5 stars [1 = lowest and 5 = highest]. The following data are used to determine a fund’s rating:

  • Historical performance – Backward looking.
  • Strictly quantitative data – No analyst input.
  • Monthly update.

As long as I can remember using Morningstar fund research, the firm has regularly posted a website article stating very clearly that a star rating has limitations and should not be used in isolation by investors to make mutual fund choices. The suggestion has always been to use it as a screening tool to identify good funds deserving of further research.

The creation of the Morningstar ANALYST RATING some three years ago has been a game changer. It uses Olympic-like “medalist” awards – Gold, Silver, and Bronze – to rate the investment quality of good mutual funds. Ratings of Neutral and Negative are also employed to indicate mediocre and poor funds, respectively.

Morningstar evaluates mutual funds on a quantitative and qualitative basis based on five key

metrics, which they refer to as “pillars:”

  • Process – Strategically, does the fund have long-term competitive advantage?
  • Performance – Over relevant time periods, are the fund’s returns positive?
  • People – What are the qualifications of the fund’s manager(s)?
  • Parent – What is the fund’s Morningstar stewardship grade?
  • Price – How do the fund’s costs and expenses compare to category benchmarks?

Using a “team approach,” Morningstar’s analyst-input in its analyst ratings is extensive.

There’s a designated fund analyst, collaborating analysts, an analyst rating committee, and a
research editor, all of whom participate in the determination of a fund’s Analyst Rating.

Morningstar only puts partial weight on backward-looking past performance.

Fund company
on-site visits and on-going communications with parent company executives and fund
managers generate a comprehensive, robust analytical framework for an Analyst Rating.

A fund’s designated analyst revisits his/her ratings on a continuous basis.

Morningstar’s
Russ Kinnel, is quoted as stating that, “We consider a fund to be, in a sense, rated every day.
In other words, every day that we come into the office and don’t change it, we’re confirming
that rating.”

As a parting comment, I would add that, currently, there are close to 200 mutual funds that Morningstar classifies as “Gold,” which it considers to be the equivalent of the “best-in-show” funds. Obviously, thoughtful selections from this elite pool are worth holding for the long haul. Interestingly, a majority of the Gold-rated funds do not have a five-star rating, and, in fact, a large number carry only two and three star ratings.

When it comes to Morningstar’s fund rating systems’ relevancy, I rest my case.

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