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Fund Spy: Morningstar Medalist Edition

The Pillars of Our New Analyst Ratings

We dig deep to rate funds for the long haul.

Our new Morningstar Analyst Ratings are more than 20 years in the making. We've been analyzing mutual funds since the late 1980s. Our analysts have been rating the best and worst funds as Picks and Pans since 1999. Throughout the next year, we will rate all the funds we cover.

In the past, we've used a four-person Picks committee to vet each fund nominated to be an Analyst Pick. Now, we have three separate ratings committees based on asset class, and we've spent the past five months vetting ratings. I head each committee, and Karen Dolan, our director of fund analysis, is also a member of each committee. Eric Jacobson and Miriam Sjoblom are part of our fixed-income panel. Dan Culloton is on our domestic-stock panel, and Gregg Wolper is on our international stock panel.

The committees aim to ensure that Morningstar's fund analysts have fully researched all the key issues on a fund and that we are treating funds in similar fashion across the board. I encourage you to read a fund's analysis so that you can understand the analyst's thought process in arriving at the rating. Our analysts have done some excellent work in fleshing out each fund's strengths and weaknesses. The better you understand a fund the better experience you'll have.

As with our picks and pans, we are rating funds based on their long-term potential for superior risk-adjusted performance. We judge each fund's competitive advantages and disadvantages to come up with an overall rating.

Our ratings have five levels: Gold, Silver, Bronze, Neutral, and Negative. We're not imposing a bell curve on the ratings but you'll see funds spread throughout that spectrum. Even some big funds will be in the Negative and Neutral camps.

The ratings reflect a synthesis of each fund's fundamentals. We break those fundamentals down into five pillars: People, Process, Parent, Performance, and Price. These are the big, fundamental areas that are vital to a fund's long-term success. However, we don't simply tally up the pillars, as each one has some overlap with the others. It's really about how they work together, and that varies from fund to fund. For example, an index fund's price matters a heck of a lot more than its people. A focused stock fund, however, is mostly dependent on people and process, so we would weight those more heavily. Let's take a look at each pillar.

There is much more to a fund than its manager. There are the analysts, traders, and other managers who contribute to the process and we consider all of them when rating people. We think about what advantages they have over their peers along the lines of expertise, experience, and demonstrated skill. A lot of work goes into assessing the people. We talk with managers on a regular basis, we visit fund companies to meet the people behind the scenes (such as analysts and chief investment officers), and of course we pore through piles of shareholder reports and press interviews from the manager, and SEC filings that show how much a manager has invested in the fund. We will also look at how other funds at the family have done to assess firmwide expertise. We follow analyst movements at the firm so we know how experienced they are and whether there's turmoil or stability in the ranks.

A negative People score does not mean we think the manager is dim or disagreeable. It could mean that the firm hasn't demonstrated expertise in that area, the research bench isn't sufficient or stable, or the manager does not have a track record.

There’s an enormous variety of fund strategies even within a category, and we drill down to really understand the differences. Competitive advantages are a key way to look at it. Is the manager doing something that anyone can do or are they doing things that are hard to replicate? Is the strategy a proven one or a new, untested formula?

Just as important is how well the process is matched to the manager and firm's skill set. For example, PIMCO runs some very involved derivatives strategies. While those are not without risks, the firm has the resources and track record to give us confidence. Someone running a three-person office would be a terrible fit for such a strategy. Mutual Series is another example of a family with a strong process. They have a deep fundamental-value strategy that they've had tremendous success with and everyone at the firm is steeped in that investing outlook. Short of hiring some people from the firm, it's not something just anyone can replicate.

When you invest for the long haul, you realize just how important the company behind the fund is. We look at manager turnover at the firm, the investment culture, quality of research, ethics, directors, SEC sanctions, and more. If you hold a fund for 15 years, you want stable management that will be there the whole way through. Failing that you want a firm with a deep bench with people who can step in and keep the fund going along the right path. What you really don't want is frequent switches with not-very-talented investors.

You'll also find that a fund company and the fund board make a number of decisions that have a big impact on the fund. Some clearly pit the company's short-term profits versus fundholders' long-term interests. For example, if they are maximizing short-term profits at the firm, they won't close a fund even if further assets could impair performance and they keep fees higher than necessary. Or they might, to the detriment of shareholders, merge two funds with distinctly different strategies. Firms seeking near-term gains sometimes launch funds that may be hot sellers but aren't great investments and won't lead to good investor outcomes. In short, you want a partner you can trust for many years to come.

We focus on performance under the current manager to tell us whether he or she has added value. The longer the record, the more predictive it is of future relative performance. Although some investors tend to weight recent returns more highly, it’s really the long-term record of a manager that is most telling.

We spend time trying to understand why a fund performed a certain way and link the performance back to its root cause: the strategy and holdings. We care about how a fund has performed in different market environments, its risk profile, and consistency of returns over time. It's important to understand what risks a manager took and is taking now to generate the returns. Some higher-risk strategies can enjoy a nice steady ride for a few years before all hell breaks loose.

We'll also look beyond the fund when necessary and appropriate by considering managers' records at other funds (current and past) as well as other accounts they may have run, such as separate accounts or hedge funds.

As I have written before, costs are a good predictor of future performance. They aren't everything, but they are a crucial piece in the puzzle. We look at a fund's expenses relative to its peer group and its sales channel. We also take into context its asset size and in some cases its trading costs if they are particularly high or low.  It's also important to consider a fund's costs in light of its strategy.

What It Isn't
The ratings distill our work on a fund, but they are not intended to do everything for an investor. Investors and their advisors have to decide what suits their needs and goals and what their plan is. Moreover, we aren't aiming to replace an advisor's due diligence.

In addition, these ratings reflect our belief about a fund's long-term prospects for risk-adjusted performance but they are not short-term calls on a fund or an asset class. Focused stock funds and a high-yield bond funds are meant to be long-term holdings and by their nature they will lose money some years.

Where We Are Headed
Today should be the beginning of a great discussion with investors, planners, and fund managers. By showing more of our work we hope to increase understanding of what’s behind each fund and therefore enable investors and advisors to choose the right fund the first time.

We will continue to look at ways to improve our new, longer analyses, the ratings, and fund data.

Over the coming months we will continue to rate more funds and we will also review existing ratings whenever we spot a shift in fundamentals. 


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