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Looking Toward Our New Ratings

And back to the record of our Fund Analyst Picks.

Russel Kinnel, 11/07/2011

We are expanding our fund-rating effort to go beyond Fund Analyst Picks and Pans as Karen Dolan wrote last week.

Later this year, we’ll give funds a Morningstar Analyst Rating: a qualitative rating of Gold, Silver, Bronze, Neutral, or Negative. In short, we are filling in the whole picture so that you'll get our take on every fund we analyze. In addition, this will help you to know how much we think a fund's prospects have changed when we change its rating. If we move a fund from Gold to Silver, you’ll know we still recommend it, as opposed to when a fund moves from Gold to Neutral.

Those of you who use our picks and pans can rest assured we will have a rating on every current pick when we make the switch. Over time we'll rate all of the funds on our coverage list.

The ratings will be long-term ratings of a fund's risk/reward prospects. They won't be attempts at calling asset class moves but rather will be based on a fund's prospects within a category.

Gold, Silver, and Bronze will all be recommended funds. We will differentiate among the three groups based on our level of conviction. Neutral funds are funds for which there isn't sufficient evidence to either recommend them or have a negative rating. Negative ratings will be given to funds that are likely to underperform on a risk-adjusted basis.

Each fund will be rated on five pillars: people (management), process (strategy), parent (the fund company behind the fund), performance, and price (expenses, trading costs, and any other fees). We will rate each pillar as Positive, Neutral, or Negative, but the overall rating won’t simply reflect a summing of these parts. What matters is how the parts work together and just how strong the fund's competitive advantages and disadvantages are.

The ratings will be subject to review at any time. For example, if a fund has a manager change or is tweaking its strategy, we'll update the rating to reflect where the fundamentals have shifted.

As with our picks, each rating is vetted by a committee of veteran analysts. We have three ratings committees to manage bonds, U.S. stocks, and foreign stocks. I head each one and Karen Dolan, director of fund analysis, is also on each panel. Eric Jacobson and Miriam Sjoblom are on our fixed-income committee, Dan Culloton is on our domestic-stock panel, and Gregg Wolper is on our foreign-stock panel.

Performing fundamental analysis on funds is nothing new for us. We've been doing this since the 1980s and our picks date back to 1999.

So, how have our picks done?

We calculate a batting average by asset class that reflects what percentage of our picks have outperformed. We also compare pick performance as if it were a portfolio competing with a broad benchmark. If a fund is made a pick in the intervening years, we add it to the portfolio and rebalance equally. Likewise, if a fund is taken off the picks list, we take it out and rebalance. Thus, we account for any fund that was a pick at any point in the five years in question.

As we transition to the new system, I’m gratified that our picks are beating the benchmarks in all asset classes over the trailing five years. In U.S. equities, the picks returned an annualized negative 0.29% compared with negative 1.18% for the S&P 500 and negative 0.57% for the Wilshire 5000. Our foreign-equity picks returned negative 1.69% compared with negative 3.46% for the MSCI EAFE.

In bonds, our taxable-bond picks bested the Barclays Aggregate 6.55% to 6.53%. In munis, our picks returned 4.29% annualized compared with 4.16% for the Barclays Municipal Bond Aggregate.

Looking at them on a batting-average basis over the same period, we also look solid. Among balanced funds, 88% have outperformed their peers. A total of 69% of international-stock fund picks have outperformed, while 70% of U.S.-stock fund picks have beaten their peers. In bonds, 86% of muni-bond picks have outperformed and 89% of taxable-bond picks have outperformed.

You can also see how any individual picks have performed by going to our Fund Analyst Picks page on Morningstar.com (Premium Membership required).

We will be writing more about our methodology in rating funds, and after they've launched we'll return to highlight some notable ratings and how we arrived at them.

Russel Kinnel is Morningstar's director of mutual fund research. He is also the editor of Morningstar FundInvestor, a monthly newsletter dedicated to helping investors pick great mutual funds, build winning portfolios, and monitor their funds for greater gains. (Click here for a free issue). Mr. Kinnel would like to hear from readers, but no financial-planning questions, please. Follow Russel on Twitter: @russkinnel.
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