A Look at Our Enhanced Morningstar Analyst Ratings

Christine Benz: Hi, I'm Christine Benz for Morningstar.com. Morningstar is launching a new methodology for rating mutual funds and ETFs. Joining me to discuss the implications of the change for index funds and ETFs, in particular, is Alex Bryan. He is Morningstar's director of passive strategies research in North America.

Alex, thank you so much for being here.

Alex Bryan: Thank you for having me.

Benz: It's good to have you here in person. Let's start by just outlining the major changes to the rating system. First of all, this is the qualitative rating that you and the analyst team do for funds, not the star rating. And also, I guess, it's important to note that we will not be rating all funds with the new methodology immediately--that this will be sort of a staged implementation. But let's talk about the major changes in this rating versus what we do today for funds.

Bryan: Sure. So, the big change is that, going forward, we're going to have more structure in the process where we're explicitly going to be estimating the type of outperformance a fund can deliver gross of fees and comparing that against what the fund is charging. So, that is going to help elevate the role of fees in assigning our ratings. So, we're going to have an estimate of what the fund can deliver and penalize it for how much it's charging.

Now, the standard for active funds is a little bit different than it is for passive funds. So, for active funds, our ratings are going to be based on our assessment of whether or not that fund is going to be able to beat its category index on a risk-adjusted basis over the long term. So, that's the standard that we apply for active mutual funds. It's the same standard that we apply for strategic-beta ETFs. Now, these are index products that are expressing active bet. So, we think it makes sense to compare it against the category index.

Now, for traditional index funds that are replicating a broad section of the market, we're going to be applying a slightly different standard where we're comparing the fund against the category average. So, we think that if an index fund can deliver better performance on a risk-adjusted basis than the average fund in the category, then that's showing that index investing is working really well in that area of the market. So, the standard is a little bit different. But what we're trying to do in both cases is steer investors toward funds that are going to deliver better performance over the long term.

Benz: So, how do the analysts go about determining how much of a return a fund can deliver before fees?

Bryan: So, this is based on our pillar scores that underpin our ratings, and we've been using a five-pillar framework in the past based on People, Process, Price, Performance, and Parent. Going forward, that's going to drop down to three pillars that are used to assess the gross-of-fee alpha potential for each of these funds. Those three pillars are Process, People, and Parent. So, Performance is dropping out, and that makes sense because performance on its own isn't a great predictor of future returns. That being said, we might still use performance to kind of gauge how good of a job that Process is doing. So, for example, if we're evaluating a quality fund, we would expect that to hold up better than the market during market downturns. If that doesn't happen, it might be an indication that there's something wrong with the process.

But when we're looking at things like process, we want to make sure that the way that the fund is put together is repeatable, that it is representative of the investment style that it's trying to capture, that it's well diversified, that the index is taking steps to mitigate unnecessary turnover, that it's easy to replicate. So, these are the types of considerations that we will look to when we evaluate things like Process. For People, we're looking to make sure that the index managers can really deliver high fidelity index tracking and do that in a cost-efficient manner. And then, for Parent, we're looking at whether or not the fund sponsor is a capable and responsible steward of investors' money. So, are they putting fundholders first or are they putting their own private shareholders first?

Benz: So, the basic pillars are the same, whether an analyst is rating an active fund or an index fund or ETF. But the relative importance of those pillars is different depending on the product type. Let's talk about that specifically with respect to passively managed products.

Bryan: Sure. So, for passive products, Process is by far the most important pillar that we're looking at. And that's because what you're getting when you buy an index fund is really the investment strategy that's codified in the index-construction methodology. The portfolio managers don't have a lot of discretion about what goes into the portfolio. Their job is just to replicate that benchmark as closely as they can. So, for passive funds, Process gets a bigger weighting in our overall assessment than People does. For an active strategy, in context, the quality of the portfolio management team can make a bigger difference because they have some discretion about what goes into the portfolio and what doesn't. So, for active, People gets a bigger weighting than it does in passive. For passive, Process is far and away the most important consideration that we're looking at.

Benz: Alex, lots to digest here. I think people will be eagerly awaiting what these new ratings look like. Thank you so much for being here to unpack it for us.

Bryan: Thank you for having me.

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

You can also read about the information provided in the Morningstar Quantitative Rating.