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Where The Medalists Are

In some categories, index funds earn higher Morningstar Analyst Ratings than in others. Russ Kinnel explains why.

Christine Benz: Hi, I'm Christine Benz from Morningstar. Where do index funds tend to dominate and in which categories do active funds rule? Joining me to discuss that topic is Russ Kinnel. He's Morningstar's Director of Manager Research. Russ, thank you for being here.

Russel Kinnel: Glad to be here.

Benz: Russ, you are on the committee that gives out these Medalist ratings to funds or that assigns funds Medalist ratings. Before we get started on this topic, can you talk about some of the main ingredients that go into a fund qualifying for that Medalist designation?

Kinnel: Sure thing. What the committees and the analysts are rating the funds are doing, is assessing the management behind the fund. That's our People Pillar. The strategy of the fund. That's the Process Pillar. The Parent, that's the fund company behind that. We're rating each one on a scale of 1 to 5, so low to high. We take all of those figures, we rate them, decide how the funds stack up essentially, based on ... Think about competitive advantages. Does this fund really have competitive advantages against its benchmark and peer groups?

Then we take all that information and then we assess--we have programs to assess--what's the return potential for that category. Then it subtracts, and then using those pillars it assigns a value, subtracts the fees for each share class, to come up with a rating. Essentially what we're saying is, we're looking at the fundamentals, but then we're also looking at returns and fees, to come out with an overall Analyst Rating from a Negative to a Gold being the highest rating.

Benz: Russ, premium users may have noticed that there are some categories where the Medalists are mainly index funds, some where they are mainly active funds. International small- and mid-caps is an area where we have a lot of index fund Medalists. In a way, this seems like a category where active managers might actually be able to add some value. Can you talk about what's going on there?

Kinnel: It's really interesting because of course, generally people think of small- and mid-caps as being less efficient and a great place to invest, but know that it really is, that's really the results of our ratings. It's not, we're not really making a macro call, but there are a couple of factors going on in this area. One is simply that the passive funds, Vanguard and DFA, are our Gold-rated funds in this area. They have a big fee advantage because as you know, foreign, small, mid funds tend to charge a lot. Most of them in the retail shares are going to charge well over 1%; their institutional might be a little below, but they're going to be pricier.

Whereas if you look at a Vanguard, I believe is 11 basis points. DFA is about 50. There's a very big fee advantage, and given our methodology, that's part of what you're seeing there, is that significant fee advantage expressed in our ratings, where only passive has Gold Analyst Ratings. We do have some Silver and Bronze actively managed funds, but really it's just capturing the fact that there's maybe a bigger fee advantage in that category than there are in many categories.

Benz: Municipal bonds are the opposite case. Russ, can you talk about that category? How there really aren't many index funds in that space, and why you and the team do tend to favor active funds there?

Kinnel: That's right. Well, I talked about the big fee advantage in foreign small/mid passive versus active. In munis, you have some very low cost, actively managed municipal bond funds. It's much tighter, which makes sense because of course the return and yield potential in munis is modest. But there's another element going on here. That is, that it's very hard to index municipal bonds, because municipal bonds don't trade a lot. It's a retail market, in other words. Municipal bonds are issued and they're largely bought up by individual investors and mutual funds, and then they're not traded a lot. So, it's very hard to index something that doesn't have that much trading.

We've got a couple of Bronze-rated index funds, but generally it's an area there that passive has ceded to active. I'm sure they'll continue to challenge active, but right now there are just some really good active funds and they are, I think, able to add value versus passive today. Again, it's interesting that here's a maybe lower-return area, but we actually like active more than passive there.

Benz: Just to clarify, the rating should not be read as a top-down call about where to go active or where to go passive. It's really based on where you see the best funds in each category.

Kinnel: Exactly. I mean, you can, from this bottom-up process, it tells you something about active versus passive, but yeah, that's not really what we're intending. Certainly, if you see in many of our categories, you'll see it's not as stark as these two examples we're giving you. More commonly you'll see some Gold active and passive, but I think it's really interesting to see what this bottom-up process can tell you about active versus passive as well.

Benz: Okay, Russ, interesting topic. Thank you so much for being here to share your thoughts.

Kinnel: You're welcome.

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