A 5-Year Report Card for the Morningstar Fund Analyst Rating

Christine Benz: Hi, I'm Christine Benz for Morningstar.com. Morningstar launched its fund analyst ratings in 2011. It's five years later, and Morningstar's director of fund research, Russ Kinnel, is here to provide some takeaways. 

Russ, thank you so much for being here.

Russ Kinnel: Glad to be here.

Benz: Russ, let's quickly recap these fund analyst ratings, what you and the team are looking for when you make your evaluations about whether a fund is Gold, Silver, Bronze, Neutral, or Negative.

Kinnel: Yeah, we're looking at fundamentals that can have an impact on a fund's long-term performance. We're not trying to make a short-term call, we're looking at things like manager and analyst, we're looking at the Process, we're looking at the Performance, Price, and the fund company behind the fund. All those things have a big impact on where the fund will go in the next five to 10 years. So we're really looking at all those fundamentals, how they fit together.

Benz: And the idea is to give a forward-looking view of how we think the fund will perform relative to its peers.

Kinnel: That's right. We're looking out over the next five to 10 years to see how we think it will do against peers and benchmark.

Benz: OK. So you have been hard at work crunching the numbers, doing sort of a preliminary look at how these funds have performed five years later. But one thing you looked at is the stability of the ratings. So the extent to which, if a fund was rated Gold initially, did it stay Gold? And one thing you found was that the Gold and Silver rated funds did, generally speaking, tend to cling to those high ratings.

Kinnel: That's right. About, of the initial rated group, 55% of the Silver-rated funds were Silver five years later, same goes for Gold, and if you're looking it as what percent of those stayed medalists, 77% of the Silver stayed medalists, 88% of the Gold stayed medalists. So relatively stable of that initial group.

Benz: OK. A little less stability among the neutrally rated and Bronze-rated cohorts. Let's talk about that and why you think there was a little more fluidity in the ratings for funds within those analyst rating rungs.

Kinnel: Yeah. It's interesting. Only one third of Neutral-rated funds stayed Neutral-rated over that whole five-year period, and 18% of Bronze were Bronze at the end. I think there's a couple key things. One is we're not the only ones noticing that a fund is less successful. A fund company might, too, and so I think Neutral and Bronze funds were probably more likely to make changes in strategy and people, and then I think another part of that is that when we adjust our coverage list, naturally we're more inclined to cut from mostly Neutral, but occasionally Bronze. So that's another element. You saw a greater percent of those funds from that first group ended up not being rated today. So you put the two together and you do have less stability in that Neutral and Bronze group.

Benz: You also noted that when the ratings initially launched in 2011, there was a little more ... there was more of a disposition toward highly rated funds, and that has changed a little bit as you've been doing more of these ratings. Let's talk about why that is.

Kinnel: That's right. So we didn't rate all the funds on our coverage list until about summer of 2012, so if you start with that initial group that we rated in November 2011, we made a conscious effort to start with all the former Analyst Picks, [which] were more or less the equivalent of Gold-rated funds, plus a lot of the biggest funds. So what that meant was it skewed heavily to the higher ratings, so in the initial group, we had more Gold-rated funds than any other group, then Silver was next, then Bronze, then Neutral. Today it's the reverse; we have more Neutral than anything else, then Bronze, then Silver, then Gold. So it does mean there's a bit of a skew in that, initially, we had much higher ratings as a percentage, but, over time, we rated more of the funds, and a lot more of those additional funds were Bronze or Neutral.

Benz: So we probably have a more characteristic distribution currently than we did initially?

Kinnel: That's right.

Benz: OK. So let's take a closer look at some of the best-performing funds that were Gold-rated initially. T. Rowe Price Health Sciences had the best raw return over the past five years at 24% roughly, five-year annualized return. PRIMECAP Odyssey Aggressive Growth, also very strong returns of 21%. Let's start with the T. Rowe fund, that fund is actually down to Neutral today, despite its strong performance and despite the fact that we had initially rated it Gold.

Kinnel: Right. Initially we really liked the manager and the team of analysts behind the fund, but then the manager and a number of those top analysts left the firm, and so that really brought us all the way back to Neutral because we just don't see those strong fundamentals anymore. Obviously there's still some other good things, we like the parent, the fees are still good, but it wasn't enough to keep it a medalist, and of course healthcare has been a great place to invest the last five years. Biotech in particular, but even some of the other healthcare areas.

Benz: OK. And then PRIMECAP Odyssey Aggressive Growth, that fund had great five-year annualized returns, but a number of PRIMECAP funds, when you look at the Gold-rated funds that have the best category rankings as well, those are all really prominent on the list, whether they're Vanguard funds or whether they're funds under that PRIMECAP Odyssey umbrella. What's going on there? What has been the catalyst for such strong results over so many of the funds managed by that team?

Kinnel: Yeah, you talk about a Gold medalist having great fundamentals, and that's exactly what PRIMECAP has. It has very experienced managers, very experienced analysts, and they go deeper than most growth investors. They understand the fundamentals better, so they're able to buy on dips and therefore they don't necessarily take on as much price risk as their peers. And it's owned by the managers and analysts, which really promotes tremendous stability that you don't see at many other growth funds. So we've long been fans of PRIMECAP, and they charge reasonable prices, and with the Vanguard funds, they're incredibly cheap prices. So we've just really been big fans of these funds in general for a long time. And on top of that, they like healthcare, too, so there's been a bit of a tailwind there as their biotech and other healthcare picks have paid off nicely.

Benz: OK, so I know that they have tended to close pretty proactively in an effort to preserve the managers' flexibility. Are any of these PRIMECAP managed funds open currently?

Kinnel: Yeah, PRIMECAP Odyssey stock is still open. The Vanguard-managed ones are not. PRIMECAP Odyssey Aggressive Growth is not.

Benz: OK. Among the worst-performing funds, or the worst performing Gold-rated fund, is Vanguard Precious Metals and Mining with a 14% annualized loss over the past five years. Just a lousy category, right? A fund that we like in a niche category that has performed poorly.

Kinnel: Right. Our opinion has declined a bit on this fund, but it's actually done relatively well relative to its peer group. But even though gold and precious metals in general have had a bit of a rally lately, it's been a very tough place to be. We had a big gold rally prior to that period and since then it's really come down. So most of the story is here just that gold has not done well.

Benz: OK. We noted the PRIMECAP funds. Among the funds with great percentile rankings, there were a few Dodge & Cox funds on the list that are Gold-rated and have had great returns relative to their category peers. So this would be Dodge & Cox Stock and Dodge & Cox Balanced all landing in the top percentile of their categories.

Kinnel: That's right. We had nine Gold-rated funds have five-year returns in the top percentile, and Dodge & Cox is really kind of the value version of PRIMECAP. They also are employee-owned, have a team-managed approach, tremendous stability. People make a career there. They start out of business school and generally stay there the whole time because they like working there, they like the stability. When people retire there, they have to start selling their shares back. So it's a great vehicle for promoting stability and not exciting funds, but over the long haul they tend to get the job done.

Benz: OK. Let's take a look at the other side of the ledger. Not all the Gold funds have performed well. The worst performer in terms of its category ranking, and it has not had a great return in absolute terms, is Morgan Stanley Institutional Mid Cap Growth. I know that's kind of a boom-and-bust style fund, and is it just that its manager's strategy has fallen out of favor or what's going on there?

Kinnel: Yeah, we like Dennis Lynch, an experienced manager with good analysts behind him and a good track record, a good strategy, but the results have been lousy the last five years. They've had some medical names that haven't done well. It also had some social media names that have been hit hard lately. So you kind of have concentration at subindustry level and, as is clear from the results, it doesn't always work. So it's been a disappointment for sure.

Benz: And on the flip side, we've had some negatively rated funds that have surprised us and performed particularly well. One is this AB Large Cap Growth. It was negatively rated, now we've got it at Neutral but its performance has been really good.

Kinnel: Yeah, it's a fund that ... we rated it negatively in November 2011, and very shortly after then, Alliance Bernstein made a change to the management team, completely new management team, new process, and they've really done well since then. So I mentioned fund companies notice the same things we do, and obviously they were aware that the fund was a big disappointment and they made a change, which has worked really nicely under the new team led by Frank Caruso.

Benz: OK. And the last fund I want to hit on with you, Russ, is Templeton Developing Markets. Negatively rated and it has performed pretty poorly as well.

Kinnel: Yeah, this is an interesting case of the downside of star managers, a fact that a star manager isn't necessarily a guarantee of good performance. Mark Mobius has long been synonymous with emerging markets. When I started at Morningstar, he was one of the biggest stars.

Benz: Superstar, yup.

Kinnel: A superstar of the industry, gave these great talks. People loved the fund. We even had it in our 401(k) a long time ago, but fortunately removed it soon after I got here, and it's just a fund that's continually disappointed. And I think Templeton in general has disappointed on a number of fronts, but this is an example of a star manager where things have just consistently disappointed and things just have not worked.

Benz: OK, Russ, interesting recap of the ratings five years later. Thank you so much for being here to provide it for us.

Kinnel: You're welcome.

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