Tuesday, November 15, 2011

Morningstar Makes Move to Rate Mutual Funds Like Stocks

A sea change at Morningstar, as it is adding a brand new analyst rating (more subjective) to it's now infamous 5 star rating system.  It appears the human element will be added to try to guestimate how funds will do in the future, as the star rating system is based on past performance.

I was startled the past few years to read what % of money goes into 4 and 5 star rated funds (I don't remember the figure but it's something north of 70%), so it will be interesting to see if this new analyst rating system has such an impact.

Here is a video discussion of the topic (7 minutes) - email readers will need to come to site to view

Here are the pillars that the new analyst ratings will be based on.  (the link does an in depth discussion of the 5 pillars - people, process, parent, performance, and price.  Looks like 300 funds already are rated, with the goal to get to 1500 (out of about 8000 funds).

  • In the past, we've used a four-person Picks committee to vet each fund nominated to be an Analyst Pick. Now, we have three separate ratings committees based on asset class, and we've spent the past five months vetting ratings.
  • As with our picks and pans, we are rating funds based on their long-term potential for superior risk-adjusted performance. We judge each fund's competitive advantages and disadvantages to come up with an overall rating.
  • Our ratings have five levels: Gold, Silver, Bronze, Neutral, and Negative. We're not imposing a bell curve on the ratings but you'll see funds spread throughout that spectrum. Even some big funds will be in the Negative and Neutral camps.
  • The ratings reflect a synthesis of each fund's fundamentals. We break those fundamentals down into five pillars: People, Process, Parent, Performance, and Price. These are the big, fundamental areas that are vital to a fund's long-term success. 
  • However, we don't simply tally up the pillars, as each one has some overlap with the others. It's really about how they work together, and that varies from fund to fund. For example, an index fund's price matters a heck of a lot more than its people. A focused stock fund, however, is mostly dependent on people and process, so we would weight those more heavily.

Long form (4 pages) methodology paper here.

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