Morningstar Medalists: What Makes the Best Funds Shine

Narrator: The mutual fund landscape can be overwhelming. There are more than 8,000 funds to choose from, spread out among dozens of investment categories. Add to that the pressures of stock-market fluctuations, interest-rate movements, and global economic developments, and the stage is set for investors to make poor investment choices--or not to invest at all.

Instead of being worried about what is going to happen next quarter or even next year, investors, advisors, and institutions can use the Morningstar Analyst Ratings to find the industry's best funds--what we call Medalist funds--that will help them build solid strategic portfolios that will endure over time.

Over the next few minutes, we'll explore how the Analyst Rating differs from the star rating for funds, the components of the Analyst Rating (what we call the Five Pillars), how we monitor ratings, and how you can use Medalist-rated funds to upgrade your portfolio.

Morningstar has been analyzing mutual funds for more than 30 years. Morningstar's first fund rating, known to investors as the "star rating," made its debut in 1985.

Jon Hale, Director of Manager Research: The star rating is a measure of funds' historical risk-adjusted performance relative to a peer group. It's a purely quantitative measure that is applied to every single fund, every single share class of a fund, once it gets to a three-year record. So every fund in the universe with a three-year record has a star rating.

Stars are allocated in a normal fashion, meaning that fully one-third of all the fund share classes out there have 3 stars, one third have 5 or 4 stars (those are the best ratings), and a third have 2 or 1 stars, the worst ratings. Only about 10% to 12% of funds at any given point in time have a 5-star rating.

Narrator: In 2011, Morningstar introduced the Morningstar Analyst Rating for Funds, also known as the Analyst Rating. Funds that earn the highest Analyst Ratings are called Medalist funds.

Russ Kinnel, Director of Manager Research: We consider Medalists to be funds that are likely to outperform their peers and their benchmark on a risk-adjusted basis over a full market cycle. We rate funds Gold, Silver, and Bronze based on our conviction of the likelihood that the fund will outperform.

Michael Herbst, Director of Manager Research: The star rating is essentially an achievement test. It's a backward-looking, strictly quantitative measure of risk-adjusted performance.

The Morningstar Analyst Rating is an aptitude test--that is, looking forward how well do we think a certain fund will do versus its competitors or its benchmark.

Kinnel: The Analyst Rating and the star rating are often going to be in sync because a fund's track record is going to point you in the direction you want to go. But sometimes there is a big divergence. Let's say the manager who is responsible for all of that fund's past success has gone, and a new person has come in who really didn't have much to do with that success. Then, obviously, there is a good reason for the star rating and the Analyst Rating to diverge, and the Analyst Rating might be less positive than the star rating.

Narrator: Despite being forward-looking, Morningstar's Analyst Ratings are not short-term market recommendations. Nor are they market calls on fund categories or asset classes that Morningstar thinks might do well in the short term.

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Kinnel: We take a long-term approach because investing is a long-term game. You're saving for long-term goals like retirement, kids' college education, but also because funds are meant to be long-term holdings.

In addition, the fundamentals that drive long-term performance take a long time to come to bear. In the short term, it's mostly noise. It's really just, what are the fund's particular biases. But over the long term, you will see skill and other market fundamentals come to bear in a fund's results.

Herbst: There is a lot of evidence to suggest that investors of all types--and this includes institutions as well as individual investors--if they hinge too much on short-term performance, the chance that they'll buy or sell a strategy at exactly the wrong time increases. Our research actually shows that if you focus on the longer term, you minimize, or you at least reduce, the chance of making poor decisions in the short term.

Narrator: To decide which funds to assign Fund Analyst Ratings, Morningstar considers several factors.

Kinnel: We rate about 1,100 funds out of a universe of about 8,000 mutual funds in the U.S. We are looking for the biggest funds, but it can also be interesting funds, funds with noteworthy strategies, funds with managers we know well. Obviously, to go from 8,000 to 1,000, you've got to cut out a lot. So, we are already going to a more select list when we go to 1,100.

Narrator: Morningstar has developed a Five Pillar framework for evaluating funds. For each pillar, Morningstar analysts assign a Positive, Negative, or Neutral score. The first pillar is Process.

Sarah Bush, Senior Manager Research Analyst: When you're trying to get your arms around whether a manager has a competitive advantage, is it repeatable, one of the things you want to look at is--say you're considering a fund with a good performance record--you want to understand how did it get that good performance record and is it going to be sustainable?

For example, a fund that has a very good record because they got one or two really big macro bets right, that may raise some questions, especially if they don't have the staff or you don't have strong confidence that they are going to be able to continue to do that in a wide variety of markets.

You can contrast that against a fund that maybe is doing some macro bets at the edges but also has invested a lot in credit research and individual bond-picking, and you can see through their track record that consistently they have been able to add value on the credit side. Or, for example, on the mortgage side, a fund that's really invested in the analytics to support individual security selection--that's something where you're going to have a higher level of confidence that the fund's competitive advantage is sustainable.

Narrator: How a manager manages risk is also an important part of the Process Pillar.

Kinnel: Risk management is a really an important part of understanding a fund's strategy. The best ones are usually strategies where risk is embedded--that is, they may be cautious on price or maybe they take a diversified approach to the portfolio, or maybe they'll build cash. I think those are the most important ways to manage risk.

Narrator: When analyzing a manager's process, Morningstar analysts engage in extensive interviews with managers.

Josh Charney, Manager Research Analyst: I think a good starting place in the conversation with the manager to talk about process is the portfolio. We strive to really understand the portfolio as well as any outsider can. One of our competitive advantages, of course, is we talk to managers constantly about the ins and outs of specific companies and industries, and we have the equity research to support our analytical thinking about certain companies.

For example, if a manager comes to us and says, we're buying Apple for XYZ, our job isn't necessarily to argue with the manager. It's more so to provide a framework for our analysis to understand his decision-making.

Narrator: There's no single process that leads to investing success. But managers who score well on Morningstar's Process Pillar tend to be disciplined, long-term investors.

Kinnel: One of the best processes we see out there is run by the PRIMECAP managers, who run a growth strategy. What they do really well is they leverage the experience of the analysts and the managers there, who are more experienced and probably better investors than most other growth shops. That enables them to look for sell-offs to buy really good companies, because they have the conviction that these companies are going to rebound. This is a firm that really focuses on the long term, that doesn't punish people for short-term underperformance, and all that put together leads to one of the best processes we see.

Bush: On the fixed-income side, when we look at funds with really strong Process scores, the one that comes to mind is Metropolitan West Total Return, an intermediate-term bond fund. This is a fund that has a wide range of tools at its disposal. It's looking at macroeconomic conditions. It's doing individual bond-picking. It goes a little bit broader and deeper than what's in the Barclays Aggregate Index.

What we really like about it, though, is the very strong value discipline that shines through in terms of bond-picking, and that can be seen when you look at how the fund has performed through various environments. For example, coming into the credit crisis, in 2007 prior to 2008, they had really dialed down their corporate exposure, saying that they were really not getting paid for the types of risks in these bonds. That helped the fund do well through 2008, and then when suddenly there were lots of opportunities and values in the corporate space, they were able to pile back into that sector.

Narrator: The second Pillar is Performance.

Janet Yang, Senior Manager Research Analyst: Looking at performance is important to the process. On one hand, you don't want to get too anchored to the past, but on the other it's important to look at performance because it really is the proof statement of what the manager is doing. Is the investment process as good as the manager says it is?

When we look at performance, it's not just a matter of good performance or bad performance. It's not looking at the fund versus an index or peers. It's really looking at the nuance. In that sense, we are looking at how performance matches our expectations. Does the manager do well in frothy markets like it should, or is it holding up better in down markets like a higher-quality fund should do? And the opposite holds true. We take a closer look when a higher-quality manager is doing really well in a market like 2009, when a lot of more-aggressive or more-speculative stocks were doing well. That would be a red flag to see if they are still following the process that they say they are following.

Katie Reichart, Senior Manager Research Analyst: Morningstar focuses on long-term, risk-adjusted performance. To get a positive Performance score, a fund needs to have beaten its benchmark and peer group over a full market cycle or the manager's tenure. If it hasn't done that, it may receive a negative performance score. Or, if it hasn't really distinguished itself from the benchmark or peer group, it may receive a Neutral rating for Performance.

T. Rowe Price Mid-Cap Growth is a fund that receives a positive Performance score. Brian Berghuis has run that fund for 20 years, and he's done remarkably well versus the benchmark and peer group. The fund has only been in the category's bottom half in three calendar years out of the 22 years he's run it. That's very impressive, and it has also held up very well in down markets, which has made it easy for investors to own.

Narrator: The People Pillar assesses the fund manager's talent, tenure, and resources.

Herbst: I'd argue that there is no investment strategy where there is a single decision-maker. Anytime I'm thinking of a People Pillar score, I'm looking at the folks who support the named manager on the fund. That could be other co-managers, it could be analysts, it could be risk-management people, it could be other experts at that firm who have valuable contributions to the strategy. I'm thinking about compliance; I'm thinking about trading. Ultimately, it's that group of people who are making the decisions on how to execute a strategy day to day. So when I think about the People Pillar, I'm trying to get a sense of who that team is, how they make decisions, who is accountable for those decisions, and how effectively they are able to do so day after day after day.

Kinnel: Though theyare Pillars, they are not silos. I think People and Process are almost impossible to tear apart. The Process really needs to take advantage of the people skills they've got, and it all needs come together in a coherent well-functioning team.

I think Dodge & Cox and Oakmark are two good examples of very high People scores, but maybe a little different. With Dodge & Cox, you have tremendous depth of great analysts and managers. People make their career of it there, and they have really come together around a similar strategy. So everyone is on the same page, and you can really see the results.

Oakmark is an example where it's a smaller team. You have one manager, typically, maybe a couple of co-managers, and a couple of analysts. It's a much smaller setup, but again you have very experienced people running a similar strategy, and you get good results out of that.

Narrator: The fourth Pillar is Parent.

Laura Lutton, Director of Manager Research: The Parent Pillar is our opportunity to look at the asset management company that offers the investment. We want to see if they are a good caretaker of capital, because we have found over the years in our research that the better the caretaker of capital, the better your long-term results are going to be. Whether a firm puts you, the investor, first is important to your ultimate outcome.

Yang: When we look at stewardship and Parent, there are few things we consider. Some of them are harder, numbers-based data points, such as fees. Does the fund company offer funds that are generally well-priced and a good value to investors?

At the same time, there are other, softer aspects to the Parent and stewardship rating, and that includes things like corporate culture. Does the fund company offer a culture that's conducive to research, to making good decisions? It's a soft area that you can only learn by talking to those portfolio managers day-in and day-out, and also talking to trading and sales and executive leadership, just to see where their mindset is, and if they really are serving investors, if they are putting investors first, or if they are putting a sales or marketing culture first.

Narrator: American Funds is an example of a firm that earns high marks on the Parent Pillar.

Yang: On the corporate culture side, for example, it's a very big organization. But at the same time, they have some unifying principles that help it to stand out and to keep their portfolio managers and analysts for the long term. One of those is that they encourage long-term thinking. That means compensating their portfolio managers and their analysts based on not only one- or three- or five-year results, but also going all the way out to eight years. And I think that really gives them a competitive advantage over their peers.

Narrator: The final Pillar is Price.

Kinnel: Price is really an underrated element of funds' performance. We've done numerous studies, academics have done numerous studies, and of course Vanguard has done a lot of studies--all of them show that costs are a very strong predictor. You ignore them at your own peril.

Narrator:Based on the most recent research, funds carrying lower expenses have greater five-year total return success rates than funds weighed down by higher expenses. That's because these funds have a lower hurdle to jump to generate positive returns.

Narrator: The Five Pillars inform the analyst's rating recommendation for the fund of Gold, Silver, Bronze, Neutral, or Negative.

Kinnel: We arrive at the Analyst Rating by having the analyst submit their recommendations to a ratings committee. We have ratings committees specializing in each asset class. The analysts makes their case, the ratings committee is there to vet those ratings and make sure that the analyst has done all their work, make sure that we're being consistent so that we rate similar funds similarly. Out of that process, we arrive at the ratings.

Narrator: Just because a fund earns positive marks for all Pillars doesn't mean it automatically earns a Gold rating.

Kinnel: You may see two funds with similar Pillars--positive, negative, neutral on the Pillars--but a different overall rating. That's because each fund has different drivers. For one fund, say a focused equity fund, People is going to be enormous, Process is going to be enormous. At another fund where maybe the fund sticks to a benchmark more closely, maybe Price is going to weigh a little more heavily.

Narrator: Morningstar closely monitors all the funds it assigns ratings to.

Herbst: Anybody that is seeing a Morningstar Analyst Rating should know that that rating reflects our current thinking on the fund, and there is a real person behind that rating who is assessing it each and every day.

Hale: We take a team-based approach to monitoring our ratings over time. First of all, the analyst who has issued the rating is responsible on an ongoing basis for monitoring the funds that are under coverage. In addition to that, we have an independent person monitoring all the funds and the ratings as well. He has set up a system of alerts and triggers that he then notifies an analyst about, so that we have double coverage there.

Some of the triggers that raise a red flag for an analyst would be any significant deterioration in performance, certainly a manager change, or other changes that are happening within the firm. A lot of times, firms will notify us about an analyst change or maybe even an executive change that has come through. If they show up in our database, that can trigger these kinds of alerts. We're keeping track of all those things.

We also keep track of expense ratio changes--when a new portfolio comes in, any change that's significant in the portfolio from the previous portfolio. We alert our analysts immediately to any of those types of things that may trigger, for them, a re-rating of the fund.

Narrator: Even with regular monitoring, Fund Analyst Ratings don't change very often.

Kinnel: The reason the ratings don't change all that often is that fundamentals don't change all that often. People tend not to change that much, expenses don't change that much. The good news is, that makes it easy on investors, because if you find a good Gold- or Silver-rated fund, generally it's going to stay that way for a long time.

Narrator: When Morningstar notices a material change at a fund, it will put a fund Under Review. Once the fund is Under Review, Morningstar begins investigating the material change and its potential long-term impact on the fund.

Herbst: When we put a fund Under Review, we first reach out the asset manager to get more information about what happened. If a manager left, why? If another manager came on to the fund, why that specific manager? How will the division of labor differ? If there is something going on at the parent level, at the firm level? We assess what the impact on the fund or on the asset management part of the company may be.

Second, we take that information into account and we reassess our ratings. Sometimes there may be a material change at a fund, and once we reassess its impact, we realize that it may not have a big effect on the fund. So, we may reinstate the fund's previous rating. More often than not, however, we will make a change to the rating if we think it's warranted.

Christine Benz, Director of Personal Finance: If a fund is downgraded from Gold to Silver or even Bronze, investors shouldn't read that as a sell rating, because Silver and Bronze ratings are very strong endorsements as well. And even if a fund is downgraded to Neutral, maybe it was a Medalist-rated fund in the past, investors will want to think about the fund's role in their portfolios before making the change and also their tax position. If it's a Neutral-rated fund that you happen to hold in a taxable account and you have a big gain in that position over your holding period, you would really want to consider any tax ramifications before selling a fund simply because it was moved down to Neutral.

Narrator: The Morningstar Analyst Ratings help investors find funds that are the best of breed and expected to perform well over the long term. But how can investors put these ratings into practice?

Benz: Investors can use the Analyst Ratings to be building blocks for long-term strategic portfolios. The reason that this works so well is that when our analysts make funds Medalists they are really assuming that the investor is going to buy and hold the fund for a period of time, say over a full market cycle. You won't see us recommending funds because we have a short-term market call in mind. We won't recommend a fund because we think that interest rates are going to jump up or because we think energy prices are going to go up. We are assuming that investors are going to use the funds as core building blocks and that they will hold them for a period of many years.

Narrator: When using the Morningstar Medalist Rating to build a portfolio, investors may be tempted to focus exclusively on Gold-rated funds.

Benz: Investors might attracted to the idea of an all-Gold-rated portfolio, but there might be really good reasons to invest in a Silver- or a Bronze-rated fund. One example would be if you are a no-load investor, you want to stick exclusively with no-load funds, but there are no Gold-rated no-load options within a given fund category. Another example would be if you are choosing from a constrained menu and maybe you know you want a small-cap fund in your 401(k) plan, but that small-cap fund is Bronze-rated. That would be a perfectly good reason to use a Bronze-rated fund in that setting.

Narrator: A strategy of building a strategic portfolio of Morningstar Medalists can be lucrative over time. During most trailing periods and across all major asset groups, more than half of the Gold-rated funds have landed in the top quartile of their respective categories.

Herbst: Investors don't have any shortage of offerings or options to choose from in today's marketplace, and there's a lot to be made about the complexity of all of it. Frankly, when you boil it all down, it's not that complex. What we're trying to do with the Analyst Ratings is essentially codify that decision-making process, so that investors can free up time to focus on other things that they have on their plate.