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What Are Morningstar Medalist Funds?

Jason Stipp
Michael Herbst

Note: This video is being re-featured as part of Morningstar's December 2014 Guide to Better Investment Picking special report. This video originally appeared in 2013.

Jason Stipp: I'm Jason Stipp for Morningstar. A big component of our research for mutual funds is the Morningstar Medalist rating. These are funds that we think have an edge over their peers over the longer term. Here to give us some detail on the Medalist designation is Michael Herbst, a director of mutual fund research here at Morningstar. 

Thanks for joining me, Michael.

Michael Herbst: It's a pleasure to be here. 

Stipp: So, let's talk about the Morningstar Medalist. What is that designation exactly? What does it mean?

Herbst: So the Morningstar Medalists are funds that have been assigned a Morningstar Analyst Rating of Bronze, Silver, or Gold, meaning that those are the funds that we think are likely to outperform their category peer groups and appropriate benchmarks on a risk-adjusted basis over market cycles of at least five years. 

Stipp: So these are not necessarily short-term recommendations, or shouldn't be seen as short-term recommendations?

Herbst: That's absolutely correct. These are not short-term recommendations. They are also not market calls on what specific fund categories or asset classes we think might fare particularly well over the next year or two or three.

Stipp: OK. And you said that this is a part of the Morningstar Analyst Rating. What are the components behind the Analyst Rating? Not every fund that has an Analyst Rating is a Medalist. 

Herbst: That's correct. To assign a Morningstar Analyst Rating, we're looking at five pillars. So we are looking at the People that run the fund, the Process that they are using, the Parent organization or the firm backing that management team. We are also looking at things like Price or expenses. We're also looking at Performance, but we're hoping to get beyond what the performance was, and really shed some light on why that performance was, and what investors could reasonably expect from future performance, given the process and the people running the fund.

For each pillar, we assign a Positive, Negative, or Neutral score, and then we roll up those scores to determine the overall rating.

Stipp: So the ratings are Negative for funds whose prospects we don't particularly like against their peer group. There's a Neutral rating, and then you have the three Medalist ratings: Bronze, Silver, and Gold? 

Herbst: That's absolutely correct.

Stipp: Can you tell me a little bit about how the rating process works? You discussed the pillars, but how does the rating actually get assigned to a fund?

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Herbst: Here is how it goes: Each of our analysts, myself included, is responsible for proposing a rating on a certain fund. To do that, I would look at a range of quantitative data, qualitative data. We conduct ongoing, on-site due diligence visits and calls with portfolio managers to essentially look at all the data that we feel is relevant to assessing a certain fund.

I pull together that data. I review it. I propose a rating to our ratings committee. The ratings committee is comprised of our senior-most analysts, most of whom have more than 10 to 15 years of experience evaluating funds. The role of the committee is not to dictate the rating to me. The role of the committee is to make sure that I've done my homework, that I have looked at everything that I need to look at, to substantiate the rating that I am proposing. Once that happens, if they have follow-up questions, I'll follow through on that and ultimately publish the rating and the analysis for the fund. 

Stipp: How often is this committee meeting? Is it once a week, once every six months sort of thing, or is this more of an ongoing, every day they are meeting?

Herbst: This is an ongoing effort. This is what we do. Our ratings committees are meeting one and a half to three hours a day, five days a week, week-in, week-out. 

Stipp: You mentioned that a lot of research goes into the rating. But the research that we historically have done at Morningstar isn't necessarily different under this new rating; it's just rolled up differently?

Herbst: I wouldn't say the research that we are doing now in support of the Analyst Ratings is markedly different from what we've done historically. I should point out that we've done this for 25 years. Essentially what we try to do in designing the Morningstar Analyst Rating is codify the way that we've look at funds and present it in such a way that it makes it easier for investors to make apples-to-apples comparisons. 

Stipp: We've talked about how a fund gets rated, and then it goes to the rating committee. What about changes to that rating? How is it monitored after you determine this fund is, for example, a Gold fund?

Herbst: Our ratings are monitored on an ongoing basis. That is the sole responsibility of each of our analysts. Any rating that appears on or in any of Morningstar's products ought to be considered live, and the analyst is responsible for monitoring those ratings on an ongoing basis, and is also responsible for reviewing those ratings with the ratings committees anytime something material changes or at least twice a year. 

Stipp: And in practice, how often does a rating end up changing on a mutual fund?

Herbst: In practice, not that often. The fundamental factors that we are looking at here in terms of management teams, process, the asset management firms behind these funds--those typically don't change that often. But when they do, our ratings will certainly evolve. 

Stipp: What happens if there's breaking news and a manager leaves or something big like that? What is the process for how the rating might change in that case?

Herbst: Any time something material changes, and that could be a manager departure, something happening at the parent organization, changes in expenses, what have you, our analysts are responsible for putting a rating under review. That typically happens the day that the development happens,  and we are tasked with reviewing that rating and vetting it with the ratings committee, and publishing a new rating and a new analysis within two weeks. 

Stipp: So, breaking news, you may see your fund go under review, but you can expect there will be a follow-up and possibly a new rating on that fund within a couple of weeks of that news event?

Herbst: That's correct. We are pretty strict on the two-week period, because investors are making decisions based on these ratings and this analysis, so it's our responsibility to get that up as quick as possible. 

Stipp: Since you mentioned investors, let's talk about the ways that an investor might use these ratings. It's rolling up a lot of great qualitative research. How would I put it to use in an investment process?

Herbst: We find that investors are using the ratings in a variety of ways. Some investors or advisors are using them to screen for new ideas. Others use them as a second opinion on their own work, if you will. Others use them to narrow down a set of choices that they're looking at. 

We designed the ratings to be used in combination with or to augment some of the other data points that folks are already looking at. So, for example, we have the Morningstar Rating, the star rating. Our analysts don't have any input into that. That's strictly a historical, backward-looking measure of risk-adjusted performance. In contrast, the Morningstar Analyst Ratings are are a qualitative, analyst-driven rating based on what we feel investors could expect from a fund's performance going forward, based on the other things driving it.

Stipp: So it's possible that a fund could have a mediocre or even a low star rating, which is a backward-looking rating, but a better Analyst Rating, because looking forward, its prospects could be brighter? 

Herbst: That's exactly right. There are cases where we have highly [analyst-rated] funds that may have 2- or 3-star [Morningstar] ratings. There are many funds that have 4- or 5-star ratings that we don't necessarily feel as strongly about their prospects going forward.

Stipp: Because these ratings also have the research behind them, the pillar research, the actual thesis on the mutual fund, even if you might tend to disagree with the rating, there's still some good information there that might be able to help you make a decision. 

Herbst: That's the idea. Honestly, if folks disagree with our opinion, we accept that, and that's OK. We actually welcome those kinds of conversations. But we do feel that the data that we are providing and the things that we are looking at to drive the [Analyst Rating] and the analysis itself should help everybody make better-informed decisions. So, if you agree with an opinion that we have on a fund, that's fine. If you disagree, and you still can find some value off of the rating itself or what we've written, then we've succeeded.

Stipp: Michael, some great research behind a very interesting and very important rating for investors. Thanks for joining us today and giving us those details. 

Herbst: My pleasure. Thank you.

Stipp: For Morningstar, I'm Jason Stipp. Thanks for watching.