Significant Fund Upgrades and Downgrades

Christine Benz: Hi, I'm Christine Benz for Morningstar. It's been a year since Morningstar's manager research analysts changed their methodology for rating mutual funds. Joining me to recap the changes, and to discuss a couple of notable fund changes, is Russ Kinnel. He is Morningstar's Director of Manager Research.

Russ, thank you so much for being here.

Russ Kinnel: Glad to be here, Christine.

Benz: So, Russ, let's talk about the changes. It's kind of involved, but maybe you can summarize the main changes that investors should be aware of with respect to these Medalist ratings.

Kinnel: That's right. On November 1st, 2019, we implemented some key changes to our ratings methodology. We maintained our three pillars of People, Process, and Parent, but eliminated Price and Performance. And what we did is meld quantitative and qualitative. So, those qualitative pillars are still there. But on the other hand, we did a couple of quantitative things.

One is, we looked at the implied value-add for each category. And the way we arrived at that was by looking at many years of return history to see how big are the returns, as well as how wide is the variation in returns in that category. And that, combined with the pillars, led us to a pre-fee alpha. Then we subtract each share class's expense ratio to arrive at our ratings. So, if it's got an implied positive alpha after all of that, it's going to be a Medalist. If it's got below that, it's going to be a neutral or a negative. And another change, as I just implied, is this time we are breaking out share classes. So, one fund with many share classes can have multiple ratings, whereas before we emphasized the biggest share class to arrive at the rating for all share classes.

Benz: So, to use a simple example on a category like short-term bonds, say, where the range of expected returns is really quite small, it's harder for funds to be Medalists or certainly harder for higher-cost funds to be Medalists?

Kinnel: That's right. It's really harder for both. So, where you're seeing a lot of the movement, it is in these lower-return categories. You've seen more downgrades. But you're right, especially if you have high fees. But of course, we're already factoring that in before. But I think it's even tougher now. And then, even middling to relatively low fees, even those funds are having a little harder time maintaining a higher Medalist rating.

Benz: In the recent issue of Morningstar FundInvestor, you looked at the number of funds that had seen downgrades since the change to the methodology. So, of our broad coverage universe, it's actually a lot of funds that were downgraded. Can you talk about that why that was?

Kinnel: That's right. When you look at it on a share-class basis, you see a very big shift downward. And again, that's because we are freeing up all those share classes. And so, let's say, an American Funds' fund that's got maybe 15 or 20 share classes, historically, we would have based that largely on the A share, which is relatively cheap. But now, you've got B and C shares, you've got cheap retirement shares, you've got expensive retirement shares. But all of those more expensive ones are going to be falling down in our ratings grid. So, you really had a significant move from the Golds and Silvers into Bronze and Neutral, and even from Neutral into Negative.

Benz: Universe of funds in the FundInvestor, Morningstar FundInvestor, the FundInvestor 500, actually saw fewer downgrades than the broad coverage universe. Why was that?

Kinnel: That's right. So, I use it to illustrate how it really depends on your perspective. So, the Morningstar 500 funds, we only have one share class per fund and the emphasis is on no-load, fairly cheap funds, though they have to be available for individual investors. So, it's not the cheapest or some institutional share classes that are out there. But by and large, these are fairly cheap funds. So, the shift in methodology only resulted in a minor tweak in the ratings for these funds.

Benz: Let's look at some specific examples starting with a fund that saw a downgrade. It's a fund that we like, it's still a Medalist, but T. Rowe Price Summit Municipal Intermediate PRSMX did take a ratings drop. It dropped down a rung. What were the main causes of that?

Kinnel: That's right. So, the model sees muni returns are fairly modest and tightly bunched. And as a result, we saw a lot of muni funds get downgraded. So, T. Rowe, as you mentioned, has positive pillar ratings for all three pillars, yet the fund fell from Gold to Bronze because its fee is relatively cheap but not super-cheap and then, of course, there's a return compression going on. So, overall, munis were one area where we saw a significant impact.

Benz: Vanguard Small Cap Growth VSGAX is a fund that actually jumped up in ratings. I'm guessing costs were part of the story, but walk us through that one.

Kinnel: That's right. Costs were part of the story. But the other part is that small-cap funds have had pretty good returns but also widely dispersed returns. So, our model is more forgiving there. So, both low-cost and middling-cost funds alike have ascended a bit in our ratings there and the Vanguard fund went from Silver to Gold as probably the cheapest fund in the entire category.

Benz: Last question for you, Russ, is we have the Star Ratings still. Discuss how investors should use the Star Rating alongside these Medalist ratings. What should they know about the two sets of ratings?

Kinnel: Yeah. So, the Star Rating is a purely quantitative measure of past three-, five-, and 10-year performance that's risk-adjusted. So, the Star Rating is a really quick way to find out how has this fund performed. The Analyst Rating is a forward-looking fundamental-driven but also has some quantitative elements in it. So, that's much more "here's our analysts' view on the likelihood that this fund will outperform its benchmark." So, they are really two fairly different things even though they are kind of a snapshot view of an individual fund.

Benz: Okay, Russ, great recap. Thank you so much for being here.

Kinnel: You're welcome.

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