What's Behind Recent Fund Upgrades and Downgrades?

Christine Benz: Hi, I'm Christine Benz for Morningstar.com. Morningstar's analysts provide ratings on about 1,400 mutual funds. Joining me to discuss three funds that recently saw upgrades, as well as two recent downgrades, is Russ Kinnel. He's Morningstar's director of manager research.

Russ, thanks for being here.

Russ Kinnel: Great to be here.

Benz: Russ, before we get into this Analyst Rating, let's just talk about how it's different from the Star Rating because there's lots of confusion about our different rating systems.

Kinnel: That's right. So, the Star Rating is a purely quantitative, backward-looking measure of the trailing three-, five-, and 10-year returns relative to category. The Analyst Rating is a mix of quantitative and qualitative that's forward-looking, assessing essentially how likely is this particular share class to do relative to its assigned benchmark.

Benz: You and the team recently instituted some changes to the rating system for the Analyst Ratings. Let's talk about the highlights. We've talked about this before, but just to make sure everyone's up to speed on what's going on with those Analyst Ratings.

Kinnel: That's right. So, now, it's a mix of quantitative and qualitative. The qualitative side that remains is we still are assessing the Parent, People and Process, and on a scale of 1 to 5--how good they are, what their competitive advantages are. But now, we're also assessing, in a quantitative way, we're assessing what's the alpha potential, what's the return potential of each category? And then we're looking at each share class' fee level and subtracting that from that alpha to then say, what is the return potential of this fund, so that there are funds that have different share classes get different ratings, which I think makes a lot of sense. Obviously, a fund charging--a share class charging 150 basis points has a harder time of beating its benchmark than one charging 70 basis points. So, it's a little more complicated but I think the end result is better.

Benz: We're going to highlight some funds that recently saw changes. Let's start with the good news, the upgrades. Vanguard Developed Markets Index is one that recently went from Silver to Gold. I'm interested in this one because this is a fund that my husband and I own in our taxable account. So, let's talk about what drove the ratings change. It sounds like this one did sync up directly with this change to the rating system.

Kinnel: Very much so. So, this is a fund that's always been a high Silver really, because it's super cheap and it covers a huge part of the world. It's essentially the world minus the U.S. and minus emerging markets, so developed markets. And super cheap--7 basis points is about as cheap as you can get. But under our new methodology, that low cost bumps it up. Before we had the Vanguard Index that included emerging markets. That was our Gold. And we sort of--we're slicing it very thin by having this one, one notch down. Because of that, this moves it up to Gold; obviously, very comfortable with it being Gold because I think it does very much what you want an index fund to do--provide dependable, diffuse, diverse exposure at a very low cost. So, it's a great fund, obviously.

Benz: Good choice on my part.

Kinnel: Well done.

Benz: Let's talk about BlackRock Total Return. This is one that I think is interesting because it illustrates that not all share classes of the same fund get the same rating. Some of the share classes are moving up to Gold; some are sitting at Silver.

Kinnel: That's right. Because again--and you see this particularly with bond funds, because obviously bonds have a more limited return potential. And so, you'll see a lot of bond funds have, say--their cheapest share classes will be one level and their less cheap will be another level. Because obviously, again, you have a fund that might charge 50 basis points here and 100 basis points there. And that's a big difference for a core bond fund. And really, when you think about it, it's an important difference for your savings, reaching your goals, not just a hypothetical issue. So, in this case, the BlackRock fund, we think very highly of it. We have rated it high on People. And I think really, it's all just come together. This is a very deep firm, and Rick Rieder has really done a great job there of bringing together a strong team, a good process. BlackRock is just a massive firm with good technology. And you see a lot of those things coming together. And BlackRock has also been making an effort to lower fees across just about all of their lineup. So, that obviously helps in our 2.0 methodology that places maybe an even greater emphasis on fees.

Benz: Let's look at T. Rowe Price Communications and Technology. This one's also going up to Gold despite some changes behind the scenes. So, let's talk about what drove the movement from Silver up to Gold?

Kinnel: Yeah, this is one that I think is very much driven by our new methodology. Because the methodology is really saying, What's attractive relative to the benchmark within this category? And the communications category is a very small category of just a few funds, many of them are fairly pricey. So, on the one hand, you have relatively high fees, but on the other hand, you have fairly high return potential according to our measurement of past return dispersion. And so what that adds up to is, even though we've got People at Average because of a manager change, that we have Process at Above Average, Parent at High, and the fees are quite cheap relative to peers. So, you put that all together in the model, puts it at Gold, which is obviously kind of a departure from our old methods. But you can see it when you're saying, What are this fund's chances relative to the other funds in its peer group?, and you say, well, this is definitely the fund I would want to own. And so, from that lens, you can understand why you get to Gold.

Benz: A related question though is that even though this fund is top-tier within its category, how do someone use a fund like this in a portfolio?

Kinnel: I would say carefully because, as you imply, I think no one needs a communications fund. And certainly, you wouldn't want a large sum of your assets in such a narrow niche …

Benz: You probably have exposure to it if you have other diversified funds to begin with.

Kinnel: Yeah, a lot of core funds are going to have communications. I think most communications stocks are going to be in the value or blend part of the Style Box. So, I think almost--you'd use it almost like an individual stock. So, maybe I want to play communications for whatever reason, but keep it a small holding. I would not go above 5% of my portfolio in such a narrow niche fund.

Benz: Let's move to the negative side of the ledger, talk about Goldman Sachs High Yield. This is one that we had at Neutral; it's moving down to Negative. Let's talk about what's going on there.

Kinnel: That's right. And in this case, it's not a methodology issue. It's that we see fundamental deterioration and a couple of fronts in this case. We had a manager departure, late 2019. But also, we've had some disappointing execution over the years. The idea is that it's supposed to be somewhat on the conservative side of its peer group. And yet, in a number of down periods, it's actually underperformed because it's had some holdings that didn't work out so well. So, on the one hand, you have the People downgrade, but we also downgraded Process because we saw those execution issues. And so, all in all, it's not a very appealing package.

Benz: Federated Muni and stock Advantage is another one going from Neutral to Negative. Let's talk about the situation there. It sounds like some manager issues in the game here, too.

Kinnel: Yeah. So, again, we've downgraded People and Process, and you have a couple--really a lot is in flux at this fund. So, the basic concept of the fund is that you take equities and munis, put them together in a balanced fund, you get a nice tax-advantaged yield from the munis. But the execution hasn't been great. You have a manager left--the lead manager left the firm not too long ago, and then following that Federated decided to merge the Clover Value Fund team up in Rochester and have them move to Pittsburgh to work with the Federated Value team. Both teams have been underperforming, both teams do somewhat different versions of value. So, when you see the "under construction" signs up, it's usually a good sign to stay away. And I think that's the idea in this case is that you don't really know how that merger will work. You don't know if people really stay. And so, really a lot to worry about in a case like this. Will the people really embrace merging in these teams, will there be changes to the strategies because you're, kind of, combining these firms that had somewhat--these groups that had different strategies? So, there's a lot that's up in the air. And overall, the fund hasn't done all that well, even if you compare it with the small subset of funds that also do this balanced muni-equity approach.

Benz: Russ, thanks for being here to share your perspective.

Kinnel: You're welcome.

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