Sunday, January 29, 2012

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.


  1. Isn't all rating, no matter how you slice it, backwards looking? Unless you got a wizard tied up in your closet, all forward looking ratings are still based on historical elements. And don't fault Morningstar for being positive. When you get to a certain size and importance, you are better served by being excessively positive than negative. If anything, blame the investors for continuously buying into the noise.

    1. You are correct, all forward projections require the use of historical elements.

      However, in regards to being excessively positive, I don't see how that ever is a benefit to investors. In fact, when you "get to a certain size and importance" I think your responsibility for pointing out risks should grow not shrink (Moody's and the rest did nobody a service with their excessive optimism). And the reality is the majority of mutual funds under-perform their benchmarks....Morningstar's rating system should reflect this unless they honestly believe this will not be the case in the future...

  2. As we noted when we launched the Morningstar Analyst Ratings for funds in November 2011, initially there will be more positively rated funds than Neutral or Negative because our analysts are prioritizing funds with the most investment merit and investor interest, which tends to skew toward higher-quality funds. The ratings distribution will even out over time as our analysts ramp up their coverage.

    We plan to assign the new Analyst Rating to 1,500 U.S. funds by the end of 2012, focusing on funds that have garnered the most investor interest and assets, collectively representing more than 75 percent of industry assets. In addition to the largest funds, our analysts will devote a portion of its coverage universe to smaller funds with distinguishing characteristics.

    1. @Nadine, I will be looking forward to seeing the ratings distribution coming closer to evening out (but in reality the distribution probably shouldn't be even, it should skew largely to neutral and negative).

      Although, with 21 index funds receiving metal ratings which are supposedly reserved for funds with "sustainable advantages" over their relevant benchmark ......I'm sure you can see why I think their should be skepticism towards the way these ratings are being allocated. I would be interested to hear the justification for giving index funds anything higher than neutral.

      You guys define neutral as "Fund that isn’t likely to deliver standout returns, but also isn’t likely to significantly underperform" and that is an index fund.

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  4. "D" who commented above hits the nail on the head. Of course all ratings are based on history. What else is there? I enjoy the analyses that state that they know that past performance does not indicate future returns, then go on to tout funds because of their 1,2,3 year total return success. Some of the subjective analysis provided by Morningstar and others has value. But how can you tell the good from the bad? The most direct way would be to find analysts whom you could trust: sort of like finding fund managers you can trust. Bottom line on Morningstar's new service is that no one knows how valuable the increased focus by presumably talented analysts will be. We will need to wait at least a year. FundRevealSM is a tool that unabashedly relies on metrics based on past performance with no qualitative analysis (I am part of the FundReveal team). The difference between the FundReveal historical analysis and others is the focus on the risk and return couplet over time to find the funds that demonstrate good investment decision-making capability. The individual investor or advisor can take objective quantitative analysis and apply his or her own analytic capabilities, or the FundReveal output can be used on its own. A demonstration of FundReveal best funds versus the S&P 500 shows that FundReveal delivered 84% cumulative total return, while the S&P lost 9% from 2000-2002. Investors and advisors can read about the demonstration and try the tool at

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