Morningstar's Russ Kinnel sheds light on the key differences between our two fund rating systems: the Fund Analyst Rating and the star rating.
Christine Benz: Hi, I'm Christine Benz for Morningstar.com. Investors are sometimes confused by Morningstar's two systems for rating funds. Joining me to clear up the confusion is Russ Kinnel. He is director of manager research for Morningstar.
Russ, thank you so much for being here.
Russ Kinnel: Good to be here.
Benz: Russ, let's start by just giving an outline of each of the systems. We've got the [Morningstar Rating for funds]. This is the one that's been around for a long time. How does the star rating work and what is it designed to do?
Kinnel: The star rating is a measure of past risk-adjusted, load-adjusted performance over the trailing three, five and 10 years. We do that versus a peer group. So, if you look at a large-growth fund, five stars means its risk- and load-adjusted returns are better than most other large-growth funds.
Benz: So, it's not attempting to predict the future. It's strictly backward-looking, and it's strictly quantitative.
Kinnel: That's right. It's backward looking. It's quantitative. We don't have any input. Any fund with a three-year record gets a star rating except for a couple of quirky categories where we don't bother to give a star rating. So, any fund can get it. We update it monthly, and it's a good measure of where a fund has been. It doesn't tell you where it's going so much as where it has been.
Benz: A couple of years ago, we introduced a separate rating system. This is the Morningstar Medalist system. So, we are rating funds as either Negative, Neutral, Bronze, Silver, or Gold--Gold being the highest level. Let's talk about that rating system--how we come up with those ratings and what the goal of that rating system is.
Kinnel: The [Morningstar Analyst Rating] is a forward-looking, fundamentals-driven rating system. The analyst is coming up with their best estimate of the fund's prospects over the long haul. So, say, over the next 10 years is this fund likely to outperform on a risk-adjusted basis? They're looking at things like fees, parent company behind the funds, manager, strategy, portfolio--all of those things--to come up with an overall rating that's looking out over the long term. This is what we know from the star rating where the fund has been. This is telling you where we think it will go. Not that we're predicting a return, but we're saying that we think this fund will do better or worse than its peers.
Benz: So, it is versus its peers. We're not attempting to say this fund--for instance, this large-growth fund--will outperform the market?
Kinnel: That's right. We're not attempting to, say, make an asset-allocation call with these rankings. It's not a matter of [saying, for instance, that] we've decided small caps are overpriced, so we're going to lower every small-cap fund's rating two levels or something like that. We don't do that. It's more about if you've decided what category you want to invest in, we're going to help you pick the best funds.
Benz: Are the analysts doing this in a vacuum? Are they working on their own lists or is it sort of a collaborative thing when they come up with these ratings?
Kinnel: It is collaborative. The analysts do a lot of the work themselves. They are doing research, they are running screens, they are running a lot of specific data points on a fund; but they are also working with their colleagues. There will be an editor involved. They may do fund-company visits in a group, but also they are then bringing those ratings to the analyst ratings committees--which I head. The analyst ratings committees are trying to provide perspective, make sure that we're being consistent with funds, making sure we know all the history, making sure the analysts have done all of their work. So, if there are a couple of issues, we want to be sure that they know all of the facts around those issues and that that's reflected in the overall rating.
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Benz: You mentioned that the star rating is recalculated each month. What are the key factors that can cause a fund's star rating to go up or down?
Kinnel: Well, it's funny. People often ask us that, and you have to remember--because it's the three-, five-, and 10-year returns--it could have had perhaps a really strong recent three months or maybe it had three really goods months 10 years ago, and now those have rolled off. So, for instance, right now the previous bear market that ended in early 2009 is rolling off the three year and five year, obviously. So, what that means is that most funds' three- and five-year portions of their star ratings no longer reflect that bear market. So, when those shifts happen, you can see a really big shift in ratings. So, it's really about what it has done recently as well as what's just rolled out of that rating.
Benz: So, the situation you just mentioned, I think, is maybe top of mind for a lot of investors right now--that some pretty risky funds actually have good star ratings because they don't have the full 10 years' worth of performance history that encompasses that really terrible year in 2008.
Kinnel: That's right, and that's always kind of at work. The earlier bear market before that has rolled out of the 10-year numbers. So, that's always in play with the star rating.
Benz: Let's talk about the analyst rating then--how often the analysts revisit their ratings and what prompts them to take a fund up or down in terms of its rating.
Kinnel: We consider the fund to be, in a sense, rated every day. In other words, every day that we come into office and don't change it, we're still confirming that rating. So, it's really live every day. The analyst is expected to be on top of their funds every day so that if something changes, then they act quickly.
So, say, there is a manager change or a dramatic performance or portfolio shift, the analyst will update that rating pretty quickly. There are a lot of different things in play. It's a little different from the star rating in that, month to month, we're not changing it. So, the analyst rating tends to be a little more stable than the star rating. But on the other hand, you can see a more dramatic shift. For instance, T. Rowe Price Health (PRHSX) was a fund that we lowered from Gold to Neutral because the manager and two analysts left. That's pretty rare, but occasionally you'll see a much bigger shift in the analyst rating than the star rating because the fundamentals have shifted very quickly.
Benz: I think one thing people wrestle with in addition to understanding these different systems is how to use them. How should one think about using the star rating? And then also how should it work in conjunction with the analyst rating?
Kinnel: The star rating is telling me that this is a fund that's done well or poorly over the last three, five and 10 years; so it's giving me kind of a quick summary of how it's performed on a risk-adjusted basis. So, that's helpful. And if it changes, let's say, it drops and I know maybe something has changed. Maybe I should look and see--try to understand why it has underperformed.
The analyst rating, however, I think is telling you, "Here are some fundamental shifts that are very important." I think the analyst rating is better than the star rating in that way--in that it can get out ahead of changes. So, for instance, the star rating doesn't really care that the manager just changed at T. Rowe Price Health and the analyst rating really does. So, the analyst rating, I think, is maybe a better signal for investors because of those fundamental changes--the fact that we're not waiting for that new manager's issues to show up in performance. We're going ahead and changing it right away.
Benz: Russ, thank you so much for being here to describe the differences and discuss the differences between the two rating systems. It's been really helpful.
Kinnel: You're welcome.
Benz: Thanks for watching. I'm Christine Benz for Morningstar.com.
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