Morningstar Ramps Up Analyst Ratings for Mutual Funds. Positive Bias Continues.

UPDATE: 8/1/12 - You can see updated ratings as of 6/30/12 here.
-----------------------------------------------------------------------------------
Morningstar continues to roll-out its new 'forward-looking' analyst ratings for mutual funds. When I wrote about these ratings in November after their initial launch they had ratings for 349 funds. They have increased that to 410 (as of 12/31/2011). You can download the complete listing here.

As a refresher here is what Morningstar says about it's new rating system

"Unlike the backward-looking Morningstar Rating™ (often referred to as the "star rating"), which assigns 1 to 5 stars based on a fund's past risk- and load-adjusted returns versus category peers, the Analyst Rating is the summary expression of Morningstar's forward-looking analysis of a fund. Morningstar analysts assign the ratings on a five-tier scale with three positive ratings of Gold, Silver, and Bronze, a Neutral rating, and a Negative rating.

The Analyst Rating is based on the analyst's conviction in the fund's ability to outperform its peer group and/or relevant benchmark on a risk-adjusted basis over the long term. If a fund receives a positive rating of Gold, Silver, or Bronze, it means Morningstar analysts think highly of the fund and expect it to outperform over a full market cycle of at least five years."

So far it appears that this system is going to suffer from the same problems which plague stock ratings.....a lack of negative ratings. Despite the fact that the majority of mutual funds under-perform their benchmarks, only 4% of Morningstar's 410 analyst ratings are "negative".

Morningstar has still not clarified how 21 index funds have managed to receive "metal" ratings. After all, how does an index fund outperform it's benchmark? By their own definitions, the best an index fund should be rated is "neutral". Yet every index fund they have rated up to this point has received a rating higher than Neutral (with the majority getting 'gold' ratings).

Below is a chart breaking down fund attributes by each rating

Nothing too shocking here. The average fund receiving their highest "forward looking" grade also has a higher backward looking star rating. Fund expenses are lower and manger tenure is longer. The most questionable aspect comes into play regarding fund size. Many funds that performed well in the past did not necessarily do so with large asset bases, the assets usually came after the performance. With "gold" rated funds having such large asset bases on average, will they be able to outperform going forward?

I will be checking up on Morningstar's roll-out of their new ratings from time to time and will definitely check up again this time next year to see how this batch of ratings has performed.