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Have Questions About Morningstar's Analyst Ratings?

Christine Benz
Russel Kinnel

Christine Benz: Hi, I'm Christine Benz for Morningstar.com. Morningstar Analyst Ratings for funds are a terrific addition to investors' toolkits. Here to provide an overview of the ratings is Russ Kinnel. He is director of fund research for Morningstar.

Russ, thank you so much for being here.

Russ Kinnel: Good to be here.

Benz: Russ, I know that one question that you have been getting a lot about the rating is how is this different from the old star rating system that we've had for many years? Let's talk about the key difference between the two rating systems.

Kinnel: Well, I think if you think about it, they are really complementary. So the [Morningstar Rating for funds, or star rating] is a purely quantitative, risk-adjusted measure of past performance over the trailing three, five, and 10 years. So we analysts have no input on that. It's just purely a measure of how the fund has done in the past. The qualitative rating, however, is very different. It's as I said, qualitative. It's the analysts' view on the quality of management strategy, price, performance, and parent, all these things rolled up, with the idea of what's a fund's key competitive advantages or lack thereof, and what's a fund's long-term prospects going forward.

Benz: So the goal of the rating is to try to help investors identify funds that will outperform over time?

Kinnel: That's right. We're trying to tell people, these are funds with great chances for long-term, risk-adjusted outperformance. We're not trying to say, "This is a fund that's going to great next year or next week." [We say] "This is a fund where the fundamentals give it a good chance of success."

Benz: Russ you mentioned the five pillars of the rating system; that's people, process, parent, price, and performance. Are those equal-weighted? How are the analysts looking at those five pillars?

Kinnel: That's another question we get a lot, and the answer is no, they are not equal-weighted. So, you can't simply look at them and sum them up because in each case it's different. You look at fund like Fairholme. Clearly, the manager and the process are a huge part of it. If you look at an index fund, clearly the fees are a big part of it. So, each one really comes together in a different way. The analysts and the ratings committees that I head try to sort out what's the way to put that together; overall what are the fund's prospects? And then in each case it's different, and even though we have five pillars, I think of them as working together. So, [for example] process and people: Does that give the fund a competitive advantage? Is this a strategy that the managers really can do better than others?

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Benz: So the analysts rate the funds as being either Gold, Silver, Bronze, Neutral, or Negative. How often are the analysts charged with rerating the funds? How often should investors expect to see their funds get new ratings?

Kinnel: Well, really we can change them at any time. So, if a manager changes, you'll see we may put it under review and change the rating in a couple of weeks. So, really it's subject to change at any time, and we're always looking at them. It's not like it really doesn't get stale, but that said, at a minimum we're going to take it off through the process at least once a year. But really we're looking at it all the time. Analysts watch SEC Filings, performance, et cetera, so, they are really constantly monitoring their funds and so are those of us in the ratings committee. So, those ratings are really fresh.

Benz: Well let's talk about that ratings committee, Russ. I know that you head up that committee. Let's talk about the goal of the committee, and I think importantly, how do you ensure consistency, so that what one analyst views as a Silver fund is akin to what another analyst might think is a Silver fund?

Kinnel: That's really a key part of what the committee does. It helps everyone say, "Well, we rated these five mid-cap growth funds like this; where does that fund fit in? We treated these five funds with new managers this way; let's make sure were consistent."

So, we try to apply those different measures similarly so that the ratings all fall in logically, and over time we've built up an understanding and a consensus with the analysts, so that I think we're now very much on the same page. In the early days we had to kind of figure out how we really want to treat these things, but as you can see now we have this critical mass where you can really benchmark a fund but against a bunch of other similar circumstances.

Benz: Well, Russ, thank you so much for sharing your overview. I think it's been a great addition to what Morningstar.com investors have in terms of research. So, thanks so much for sharing an overview of it.

Kinnel: You're welcome. It's been a lot of fun.

Benz: Thanks for watching. I'm Christine Benz for Morningstar.com.