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An Update on the Morningstar Analyst Rating

We have more Neutral-rated funds than any other ratings level, writes Morningstar's Russ Kinnel.

Russel Kinnel, 06/18/2012

This article originally appeared in Morningstar FundInvestor.

It's been half a year since we launched our Morningstar Analyst Ratings. This is a good time to take a look at where things stand so you can have some perspective. It's too early to judge performance, of course, but we can see how the ratings are breaking down.

The analyst ratings are deep fundamental dives on a fund's prospects. We examine funds based on five pillars: People, Price, Performance, Parent, and Process. We then rate each fund Gold, Silver, Bronze, Neutral, or Negative.

So far we have rated more than 800 funds on our way to rating 1,500. It's worth keeping in mind that the 1,500 we will rate are worth covering either because they are compelling investments or simply big funds from a list of nearly 7,000 total funds. We don't have a set curve for ratings, but if we were to rate all of the funds in the United States, you'd see a higher percentage of Neutral and Negative.

As of June 12, here is the breakdown: Gold 170, Silver 192, Bronze 207, Neutral 220, and Negative 54. As we rate the rest of our coverage list, I'd expect Neutral will grow the fastest. It is already the largest bucket, and it will likely take up quite a lot of our ratings. The reason is that many funds don't really stand out either because they have short track records or long but mediocre records.

Although the ratings are subjective, they're not about our gut feelings. We gather a lot of data in doing our analysis. Besides obvious things such as expense ratios and total returns, we look at index overlap, R-squared, tracking error, and returns relative to a benchmark on a yearly basis to understand how indexlike a fund is. To understand whether a fund's asset base is bloated, we look at assets, days trading volume in top holdings, changes in total stocks, and concentration in the top 10 holdings. To understand a fund's risk levels, we look at performance on a risk-adjusted basis and at portfolio-level risks. For instance, to understand a bond portfolio, we home in on yield relative to category and benchmark, credit breakdowns, and weighting by issuer.

The subjective part comes in bringing that data together and in assessing a fund's management, analysts, and strategy. Still, the average figures for each grade level validate the qualitative process quantitatively. When looking at expense ratios, Morningstar Ratings for funds ("star ratings"), manager tenure, and investor returns figures for each group, you can see a stair step down.

For Gold-rated funds, the average expense ratio is 0.61%, the average star rating is 3.86, the longest manager tenure is an average of 12.7 years, and the average investor return ranking is 31 (15 best and 1005 worst). For Silver, the average expense ratio is 0.84%, average star rating is 3.6, longest manager tenure is an average of 11.1, and average investor return rank is 31. Those figures decline down to Negative-rated funds, which have an average fee of 0.98%, average star rating of 2.2, longest manager tenure average of 5.7, and average investor return rank of 72.2.

To see what our ratings are saying about fund companies, I calculated a GPA for the 10 biggest fund companies. I assigned a 4 for Gold, a 3.5 for Silver, a 3 for Bronze, a 2 for Neutral, and a 1 for Negative.

We still have nearly 700 funds to go, so these figures may well change depending on how good the remaining funds we rate are. Here's how it broke down.

Honor roll:
Vanguard 3.6, American 3.4, PIMCO 3.4, T. Rowe Price 3.4, JP Morgan 3.0

And the rest:
Fidelity 2.9, Franklin Templeton 2.8, BlackRock 2.6, Columbia 2.3, Oppenheimer 2.3

To get a 3.4 or better for a large number of funds, a company has to have a lot of strong suits rather than just one, though it's interesting that Vanguard and T. Rowe Price are closer to being strong across the board than American, which has weak bond funds, and PIMCO, which is only just building up a presence in equities.

On the lower end, Columbia and Oppenheimer need to improve on a lot of fronts. Columbia landed three equity funds in the Negative bin, while Oppenheimer has three bond funds, a commodity fund, and a stock fund in Negative.

Outside of the top 10, American Century received 2.6 as its funds lean toward the middle. It received no Gold ratings and only one Negative. MFS rated a 3.2 because the firm has steadily improved the quality of its research.

Updating Ratings
You'll also be seeing more changes to existing ratings, as we continue to update and monitor changes at funds. We aim to review a rating quickly after a significant event such as a manager change. However, we will also keep looking for more-subtle shifts or details we hadn't uncovered before.

For example, we took Vanguard International Explorer VINEX down a notch in May because performance continued to deteriorate and the manager given 10% of the portfolio doesn't have a long track record. Neither signals a disaster, but this illustrates how we will continue to evaluate funds after we've rated them.

Updating Performance of Our Ratings
Let's take a look at how the Gold ratings (formerly "Fund Analyst Picks") have done because that's where our track record is the longest. The other ratings levels have only been around for a few months, but over time we'll provide more information about how each level is doing.

As you can see from the graphs, the average Gold (or Analyst Pick) fund has outperformed most of the benchmarks, with the exception of municipal bonds, where some of our lower-risk muni national funds have lagged the benchmark. In our defense, you can't buy a muni index mutual fund. Versus muni peer groups, our performance has been excellent.

We hope to build on our pick success with our more-complete Morningstar Analyst Ratings. Already we have rated more than twice as many funds as we had under our Picks and Pans system. In addition, the Analyst Ratings will let you track funds that fall somewhere between our top and bottom rungs.

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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