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New Morningstar Ratings Dig a Little Deeper


Morningstar is no longer just looking backwards-focusing on three-, five- and 10-year returns. The fund ratings giant is now looking ahead to the future, as well.

Morningstar is now rolling out a new forward-looking analyst ratings system for the U.S. funds it covers. Funds will now be rated on a predictive five-point scale from "Gold" to "Negative," in addition to Morningstar's flagship star rating, which looks at a fund's past risk-adjusted performance.

The aim is to curb performance-chasing by stressing more qualitative measures and standardize some of its global practices.

About 350 funds have been rated on the new scale so far, and the company expects its analysts to eventually rate 1,500 of the biggest, most noteworthy mutual funds by the end of 2012.

"Our star ratings are a good measure of risk-adjusted performance over the long haul versus peers, but we think the analyst ratings can complement the stars well and give a measure of sustainability of the performance by looking at more qualitative factors," said Karen Dolan, Morningstar's director of fund analysis. Dolan also said that Morningstar had similar qualitative ratings in place in other countries where it rated funds, and the move will help to standardize its practices around the world.

The new ratings formula represents an expansion of Morningstar's Picks and Pans program that has highlighted the best and worst funds covered by the company's analysts since 1999. In the new system, funds are rated either Gold, Silver, Bronze, Neutral, or Negative, with a fund's overall rating reflecting a combination of assessments on what Morningstar calls its five pillars:

* People (the fund's managers)

* Process (the fund's strategy)

* Parent (the fund's parent company)

* Performance (risk-adjusted returns)

* Price (the fund's expense ratio)

How much weight each pillar carries in a fund's overall rating depends on the category, and unlike the star ratings, the ratings will not be given according to a forced distribution in which a certain percentage of funds has to receive each rating.

 

Extra Star Power

Mutual fund industry watchers expressed some skepticism about how predictive and ultimately useful the new analyst ratings will be, but gave Morningstar credit for developing new measures to supplement the star ratings.

"I'm a doubting Thomas at the moment as to the likelihood of the new system working, but I hope it does, since I think we need to do something to replace the stars system that has been, in many ways, an Achille's heel for investors who have bought funds based on them," said Geoffrey Bobroff, president of mutual fund consultancy Bobroff Consulting. Bobroff pointed out many studies have shown that investors pile into funds after they've received high Morningstar star ratings, but that's often not the best time to buy them.

Allan Roth, a financial planner who blogs about investing for CBSNews.com, said time will tell how predictive the new ratings turn out to be, but that he liked the methodology and expected the new ratings to be influential.

But Burton Greenwald, president of B.J. Greenwald and Associates and another industry consultant, pointed to the possibility for investors to be confused by conflicting star and analyst ratings for the same fund. For example, the well-known large-cap Clipper Fund has just a two-star Morningstar rating but gets a Gold designation in the new system. Conversely, the Columbia Value and Restructuring fund gets has received three stars at times in the past year, but gets only a Neutral analyst rating.

"Ultimately, investors are best served by a more comprehensive analysis of their objectives, risk tolerance, etc., and then trying to match their priorities to the characteristics of specific mutual funds," Greenwald said.

For its part, Morningstar says that wide discrepancies in the ratings are not likely to happen that often, and that they may, in fact, be useful for investors.

"I've heard some talk about [the new ratings] being confusing, but I think that's an important tension for investors to pay attention to; if there's something about recent performance that may not continue, it's important that investors do a little digging," Dolan said.

In the case of the Clipper Fund, for example, Dolan said that its positive analyst rating represents confidence in its managers and their longer-term record, while the Columbia fund's weak analyst rating reflects the fact that the fund's manager will be retiring in 2012.

As for the new ratings' impact on financial intermediaries and the fund industry as a whole, observers said it depends on how quickly they're embraced by investors. Roth said at a minimum, it will be important for advisers to be familiar enough with the new system to discuss it with clients.