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The Pillars of Our New Analyst Ratings

We dig deep to rate funds for the long haul.

Russel Kinnel, 11/15/2011

Our new Morningstar Analyst Ratings are more than 20 years in the making. We've been analyzing mutual funds since the late 1980s. Our analysts have been rating the best and worst funds as Picks and Pans since 1999. Throughout the next year, we will rate all the funds we cover.

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. I head each committee, and Karen Dolan, our director of fund analysis, is also a member of each committee. Eric Jacobson and Miriam Sjoblom are part of our fixed-income panel. Dan Culloton is on our domestic-stock panel, and Gregg Wolper is on our international stock panel.

The committees aim to ensure that Morningstar's fund analysts have fully researched all the key issues on a fund and that we are treating funds in similar fashion across the board. I encourage you to read a fund's analysis so that you can understand the analyst's thought process in arriving at the rating. Our analysts have done some excellent work in fleshing out each fund's strengths and weaknesses. The better you understand a fund the better experience you'll have.

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. Let's take a look at each pillar.

There is much more to a fund than its manager. There are the analysts, traders, and other managers who contribute to the process and we consider all of them when rating people. We think about what advantages they have over their peers along the lines of expertise, experience, and demonstrated skill. A lot of work goes into assessing the people. We talk with managers on a regular basis, we visit fund companies to meet the people behind the scenes (such as analysts and chief investment officers), and of course we pore through piles of shareholder reports and press interviews from the manager, and SEC filings that show how much a manager has invested in the fund. We will also look at how other funds at the family have done to assess firmwide expertise. We follow analyst movements at the firm so we know how experienced they are and whether there's turmoil or stability in the ranks.

A negative People score does not mean we think the manager is dim or disagreeable. It could mean that the firm hasn't demonstrated expertise in that area, the research bench isn't sufficient or stable, or the manager does not have a track record.

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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