Morningstar’s makeover of its fund medal ratings system this month couldn’t come too soon. Now that investors are flocking to passively managed index funds, research firms that rate actively managed mutual funds must find ways to stay relevant. There was a time when the lion’s share of new money flowing into funds went to active funds that Morningstar rated five stars, but its star system has lost its luster because of the indexing craze.
That may be a good thing. The firm’s star rating is based on a fund’s past performance and volatility, but it hasn’t proved to be very predictive for future performance and volatility. In 2011, Morningstar created a medal ratings system that ranks funds from Negative to Gold based on a more qualitative analysis of managerial skill. That was an improvement, but it also had flaws. It could predict with some accuracy if a fund would outperform actively managed peers in the same investment category, but not necessarily if it would beat its zero-fee benchmark.
The revised ratings system incorporates a zero-fee benchmark hurdle into its analysis. While beneficial to investors, the shift will be painful for many fund managers. Of 556 share classes rated so far under the new system, medal rating downgrades outnumber upgrades by 2 to 1, says Jeffrey Ptak, Morningstar’s head of global manager research. Among share classes formerly rated Bronze, 29% were downgraded to Neutral and 16% were upgraded to Silver.
In the past, a fund’s rating was consistent across all of its share classes for analyst-rated funds. Morningstar would base the rating on the fund’s oldest, most-popular share class, often its lowest-cost institutional one. Now, each share class gets a separate rating, with expenses factored in. As a result, Morningstar effectively downgraded the highest-fee share classes.
A prime example is the $6.3 billion-in-assets A shares of American Funds Growth & Income Portfolio (ticker: GAIOX), which dropped from a Silver rating in October to a Bronze in November (see table). In a new report, Morningstar analyst Leo Acheson writes, “The American Funds Growth & Income target-risk series utilizes impressive underlying strategies. The series’ cheapest share classes receive a Morningstar analyst rating of Silver, while its more expensive share classes earn a Neutral.” The Neutral-rated C class (GAITX) has an expense ratio of 1.42%; the Bronze A shares, 0.68%; and the Silver R5 (RGNFX), meant for 401(k) plans, 0.4%. Previously, all had been rated Silver, despite the fact that the C shares’ higher fees cause it to lag behind the performance of the R5 by a full percentage point a year. American Funds declined to comment.
Morningstar doesn’t factor sales commissions, or “loads,” into its new ratings. This is significant, since funds’ A shares typically carry commissions, while C shares embed sales costs into the underlying expense ratios. This immediately puts C shares at a disadvantage from a ratings perspective. “Our star rating used to have a load adjustment to it,” says Ptak. “But a few years ago, we removed the load adjustment from the rating calculation in view of the fact that loads were so often being waived. The percentage of sales subject to a front-end load with A shares was about 13%.” Perhaps, but for that 13%, the new ratings will be inaccurate.
Previously, the rating was based on five separately rated pillars—Parent, People, Performance, Price, and Process—which were then combined. Now Price and Performance have been wrapped into the other pillars. Ptak says Morningstar will analyze rolling 36-month risk-adjusted returns for funds versus peers and benchmark before and after fees in the Process pillar, to make projections of risk-adjusted returns. This marks a subtle shift. In the past, fees were compared to peers for an absolute Price rating. Now, fees are tied to performance to see what the value add is for them.
The new system has its critics, notably from competing ratings service CFRA, which has always analyzed fund share classes separately and incorporates other factors into its ratings. “Morningstar’s process continues to rely too much on historical performance,” says Todd Rosenbluth, CFRA’s director of mutual fund and exchange-traded-fund research. “It’s trying to predict future returns based on past-performance success, and there’s a reversion to the mean that happens when funds that outperform or underperform in one period tend to move back to the middle of the pack.” Indeed, there is a lot of research regarding this reversion-to-the-mean effect.
CFRA’s ratings are more forward-looking because they analyze a fund’s underlying portfolio, he says. “We’re looking at stocks inside the portfolio and offering a forward-looking 12-month target-price assessment of those stocks to determine if management’s best ideas are likely to succeed.” Still, being forward-looking and predicting accurately are two different things. “We have not published a performance record [for CFRA’s fund rating],” he admits. Until Morningstar’s new system has a longer track record or CFRA publishes its results, the only certainty for investors about what affects future performance is fees.