How to Use Our New Analyst Rating for Funds

Jason Stipp: I'm Jason Stipp for Morningstar.

Morningstar's fund research team is rolling out a new fund rating that's designed to help guide investors toward those funds that we think have the brightest future prospects.

Joining me to offer the details on this new rating is Morningstar's director of fund analysis Karen Dolan.

Karen, thanks for being here.

Karen Dolan: Thank you, Jason

Stipp: So, I think most investors are familiar with the Morningstar star rating, but this rating system is different than the star rating. Can you explain what some of those key differences are?

Dolan: Absolutely. The star rating is a backward-looking measure. It looks at how a fund has performed over the long haul on a risk-adjusted basis versus peers. So, it's a quantitative measure; it's risk-adjusted returns. Also costs are in there because loads are taken out, and the returns are after fees.

This new rating is very different in that it has a lot of qualitative elements to it. We have a team of mutual fund analysts here at Morningstar, who we have had for a very long time, and these analysts are doing work that goes beyond just the numbers.

[The new rating] is pulling together the entire picture about a fund. It's qualitative, it's forward-looking, and it's really just putting that stamp of the analyst judgment, and their view on whether the fund is a good purchase or not, right on the fund, up front and center.

Stipp: So, I want to talk about the specifics of the rating in a moment, but before we get to that, qualitative research is nothing new to Morningstar. We have had analysts for many years that have been looking into mutual funds and writing reports. So, what is this rating doing? What is the layer on top of that qualitative research, and how is it providing definition for that?

Dolan: Well, we've had fund analysts at Morningstar since the 1980s, soon after Morningstar launched. We've had people on staff who are going beyond just the numbers and actually analyzing what it means, trying to figure out cause and effect. We've grown that team and invested in that team over time, and users of Morningstar.com's Premium Service are probably used to the written analysis that we write about funds.

So, our analysts go through and discuss their outlook and their views, how the risks and the rewards and the portfolio, and all of those things come together in a written analysis. And we've been doing that for many, many years.

So, this reading is only a codification of that. So it's not different. It's just taking all of those views that we've had in written form and putting a clear data point on them through the Analyst Rating.

Stipp: And for years in the past, you have also had a list of Analyst Picks, which were a formalization of the analysts' favorite funds. How is this rating going to work with the picks?

Dolan: So, this rating will replace the picks. You're right, we have had Analyst Picks and Pans since 1999, and those are--really out of every fund that we cover--those were the very best and the very worst. So, we put that view on the extremes.

And what we're doing now is, you could think of this as filling in that middle ground. And so every fund that we cover will have an Analyst Rating, similar to the picks and pans, but just filling in the middle. This will replace the picks and pans, though. So, ... all of the picks will be re-rated under this new system.

Stipp: So, you mentioned that we're going to have more definition now in between those two extremes of pick and pan. So, what are the levels of the rating that readers can expect to see?

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Dolan: We have on the positive end of the spectrum, Gold, Silver, and Bronze. So, any funds that our analysts believe have enough advantages, competitive advantages to outperform over the long term on a risk-adjusted basis in the future, we will give a Gold, Silver, or Bronze rating to.

The differences between Gold, Silver, and Bronze really signal the level of our conviction regarding the full range of the fund's capabilities. So, the Gold funds really shine in every way. Silver and Bronze funds, we still think they have a very good chance of outperforming, but there may be something--it might be a slightly high price or a management team that's proven but still has to showcase how they can do in different market environments. We would still rate those positively, if we think they're going to have a good chance of outperforming, but the rating may be Silver or Bronze. So, it allows us to signal to investors between the positives.

We also have a Neutral bucket and a Negative bucket. There are funds that we cover that we think don't have a clear advantage or disadvantage, and those funds would land in Neutral. And Negative is where we think that a fund has a true disadvantage, and it's going to impede its abilities to outperform in the future. So, that's the full range of our new ratings scale.

Stipp: So, we know that investors like to screen on ratings like this. So, if they get a list of Gold fund, does that mean that this fund is a buy if they see that it has that top rating?

Dolan: Well, it's not necessarily a buy, because it's not a market call. So, we're not going to go in and say, "OK, we are going to make all the emerging-markets funds Gold now, because we think now is a good time to buy emerging markets." That's what a buy means to me.

I would say that after an investor looks at their portfolio, and they want to buy a fund to fill their asset allocation plan and to fill a need in their portfolio, they can then go look at what our Gold-, Silver-, or Bronze-rated funds are, and assess which one is the right fit. So, it's a buy in that it's a good fund for the long term, and it can fulfill a portfolio need. But the timing of how somebody is going to be using it, or increasing or decreasing their positions, that is not the intention here.

Stipp: So, a lot of things can obviously affect funds in different categories. We're not saying that you're going to see positive market performance out of the gate from a Gold-rated fund. It just means if this is a need in your portfolio, this is certainly a fund to take a closer look at?

Dolan: Absolutely. It's not a short-term recommendation. So we're not trying to tell you which fund is going to outperform over the next three months or year. It's really a long-term view on a fund's capabilities.

Stipp: So, Karen, as part of the extra definition that's being added to the analyst research, there is also a more, I would say, codified way that they are looking at funds, and exactly the pillars that they're using to come up with this rating. Can you go into some detail about what goes into this?

Dolan: Yes, this has been a really nice way for us to take the research that we've been doing for all of these years and codify the methodology. We've always had a methodology looking at the people on the fund, the process, but this has forced us to really crystallize that.

So, we like to call the basis of the rating The Five Pillars; that's how we refer to it. Those five pillars are People, Process, Parent, Performance, and Price. So, those are all of the things that we look at when we are analyzing a fund.

We look at the numerically-based factors, we look at qualitative factors, and we really see how those things come together in the full picture for an individual fund.

Stipp: So readers will be able to look into the Analyst Report and see what your take is on these different pillars, and they'll really understand what's gone into that rating?

Dolan: Yes. So, in addition to the Analyst Rating, we are also going to have a view on the pillars. So, if you see that a fund is rated a certain way, you'll be able to also see which of the pillars do we have a positive view on, or we are neutral on, or we have a negative view on, to really try to assess how that whole picture comes together to lead to the rating.

Stipp: So, lastly, Karen, this is obviously a very big endeavor for the fund research team. This is something that you're going to be rolling out over time. Can you give us a sense of when we'll expect to see these new reports and how many we'll see to start with and what you'll be doing afterward?

Dolan: ... We're not going to be re-rating our entire universe right off the bat. We are going to be working toward that throughout 2012, but what you'll see from us through the end of 2011 is about 300 to 400 funds will be rated, and then we are going to work up over time. ... We have to keep up with the ratings that we've already launched. So, we have to balance that maintenance of the research that people are relying on us for with the ramp-up of the new ratings. So, throughout 2012 we expect to ramp up to about 1,500 funds rated in this new system.

Stipp: Well, Karen, an exciting new rating. Thanks for joining me today and offering the details.

Dolan: Thank you. Thanks, Jason.

Stipp: For Morningstar, I'm Jason Stipp. Thanks for watching.