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Analyzing the Morningstar Analyst Rating™ for Funds

Why we looked at the rating and what opportunities we found to improve it

Jeff Ptak, Morningstar Research Services LLC

 

The Morningstar Analyst RatingTM has done a good job in helping predict funds’ future risk-adjusted returns, with higher-rated funds generally outperforming lower-rated funds, according to a recent Morningstar study. That said, the study also identified areas where there’s opportunity to improve the way that analysts assign ratings.

Launched globally in November 2011, the Analyst Rating is a forward-looking assessment of a fund’s ability to outperform its peer group or a relevant benchmark over a market cycle, after accounting for risk and expenses. The Analyst Rating takes the form of Gold, Silver, Bronze, Neutral, or Negative, with Morningstar Medalist ratings reserved for funds the analysts have higher conviction in.

How we studied the Analyst Rating’s performance

We analyzed the returns of more than 4,500 unique open-end funds globally that were assigned Analyst Ratings between November 2011 and April 2017, including dead funds. (We tracked subsequent returns of rated funds through Oct. 31, 2017.) We evaluated rated funds’ performance using two techniques: a cross-sectional regression and an “event-study” framework. For more details on our analysis and findings, read the full research paper.

Our analysis shows that the Analyst Rating exhibited certain predictive abilities during our sample period, though the strength varied between asset class. Using the regression technique, we found the Analyst Rating was most predictive during the sample period among equity and allocation funds, where Gold-, Silver-, and Bronze-rated funds significantly outperformed Neutral-rated funds after accounting for expenses and common risk-factor exposures.

Our findings were similar under the event-study method: The average Gold-rated fund in the study produced 0.76% per year in alpha (versus a relevant category index) over a 60-month event horizon whereas the average Neutral- and Negative-rated fund in the study earned negative 0.04% and 0.22% of alpha per year, respectively. Taken as a whole, we found in the study that the Analyst Ratings effectively sorted funds based on their average future risk-adjusted returns

Opportunities we see to improve the Analyst Rating

One of the main reasons we conduct performance studies like these is to transparently assess how well our ratings have done and to help identify strengths and weaknesses that we believe we can build upon. In that spirit, it behooves us to reflect on where the opportunities are to improve.

First, we would like to improve our risk-unadjusted performance. For example, the average Silver- and Bronze-rated fund suffered negative excess returns versus the category index. We also need to better identify underperforming funds in advance, as the average Neutral- and Negative-rated funds achieved positive excess returns compared with the category average. The Analyst Rating’s performance strengthened once we accounted for risk, but we realize that some investors may define success as outperforming an index before risk.

Second, at times, we observed that Silver- and Bronze-rated funds did not perform much better than lower-rated funds, on average. To meet its objective, the Analyst Rating should predict differences in future performance, with high-rated funds outperforming low-rated funds monotonically. We need to determine ways to achieve better separation between ratings rungs.

Finally, while the Analyst Ratings of U.S. funds generally met its objective in sorting funds based on future risk-adjusted performance, this was less evident when measuring based on future excess returns, especially among stock and bond funds. To be sure, market conditions have been challenging for some types of active funds, and this in turn has likely weighed on ratings efficacy. But it’s important that we seek to achieve greater separation and slope across the rated universe.

Predictive Power

Despite these shortcomings, the findings are encouraging. It’s important to remember that the Analyst Rating has yet to perform through a full market cycle. But on balance, the rating appears to have met their objective in sorting funds based on future excess returns, though its predictive ability varied depending on the event horizon, asset class, or measurement technique used. The findings reveal areas of weakness, and those insights will help animate future efforts to continually innovate and improve the Analyst Rating.

This blog post is adapted from an article that originally appeared in the February/March 2018 issue of Morningstar magazine. Read the full article.

Please see below for important disclosure. 

Read our full study and analysis of the Morningstar Analyst Rating for funds.

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Important Disclosure

The Morningstar Analyst Rating is not a credit or risk rating.  It is a subjective evaluation performed by the fund analysts of Morningstar, Inc.  Morningstar evaluates funds based on five key pillars, which are Process, Performance, People, Parent, and Price.  Morningstar's analysts use this five-pillar evaluation to identify funds they believe are more likely to outperform over the long term on a risk-adjusted basis.  Analysts consider quantitative and qualitative factors in their research, and the weighting of each pillar may vary.  The Analyst Rating ultimately reflects the analyst's overall assessment and is overseen by the Morningstar Analyst Rating Committee.  The approach serves not as a formula but as a framework to ensure consistency across Morningstar's global coverage universe.

The Analyst Rating scale ranges from Gold to Negative, with Gold being the highest rating and Negative being the lowest rating.  A fund with a Gold rating distinguishes itself across the five pillars and has garnered the analysts' highest level of conviction.  A fund with a Silver rating has notable advantages across several, but perhaps not all, of the five pillars- strengths that give the analysts a high level of conviction.  A Bronze-rated fund has advantages that outweigh the disadvantages across the five pillars, with sufficient level of analyst conviction to warrant a positive rating.  A fund with a Neutral rating isn't seriously flawed across the five pillars, nor does is distinguish itself very positively.  A Negative-rated fun is flawed in at least one if not more pillars and is considered an inferior offering to its peers.  Analyst Ratings are reevaluated at least every 14 months.

For more detailed information about the Morningstar Analyst Rating, including its methodology, please go to: http://corporate.morningstar.com/us/documents/MethodologyDocuments/AnalystRatingforFundsMethodology.pdf

The Morningstar Analyst Rating should not be used as the sole basis in evaluating a fund.  Morningstar Analyst Ratings are based on Morningstar's current expectations about future events; therefore, in no way does Morningstar represent ratings as a guarantee nor should they be viewed by an investor as such.  Morningstar Analyst Ratings involve unknown risk and uncertainties, which may cause Morningstar's expectations not to occur or to differ significantly from what we expected.

The information, data, analyses and opinions presented herein do not constitute investment advice; are provided solely for informational purposes and therefore are not an offer to buy or sell a security; and are not warranted to be correct, complete or accurate. The opinions expressed are as of the date written and are subject to change without notice. Except as otherwise required by law, Morningstar shall not be responsible for any trading decisions, damages or other losses resulting from, or related to, the information, data, analyses or opinions or their use. The information contained herein is the proprietary property of Morningstar and may not be reproduced, in whole or in part, or used in any manner, without the prior written consent of Morningstar. Investment research is produced and issued by subsidiaries of Morningstar, Inc. including, but not limited to, Morningstar Research Services LLC, registered with and governed by the U.S. Securities and Exchange Commission.​

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