The fund world's most influential grader is about to get tougher. Morningstar, the fund ratings company that has for years bestowed stars on top performing funds, has announced a new ratings system that threatens to upend the fund universe, turning fund frogs into princes, and vice versa.
As of this fall, Morningstar will unveil what it calls its "analyst rating system," which will emphasize analysts' judgment in trying to predict which funds will deliver solid performance in the future. In contrast with the star system, which is strictly based on past performance, funds' new grades (from AAA to 'negative') will also take into account Morningstar's assessment of fuzzier factors, like the thoroughness of the stock-picking process, the talent of the portfolio manager, and the stewardship of the fund company. It'll emphasize expenses more than the current star system does, and it'll be more responsive to changes in a fund's management or portfolio construction.
And while the star ratings aren't going away, the addition of the new scoring system could have a huge impact on the fund world. What Morningstar says carries weight, says Lee Kowarski, a principal with financial services consulting group kasina. "Certainly, the negative ratings will be very damaging. And over time, if triple-A rated funds consistently outperform double-A or single-A, then [the analyst ratings] could become even more important than the star ratings."
As it is, research has shown that Morningstar's star ratings can be highly influential. A fund whose debut rating is 5 stars gets 53% more inflows over the next six months, compared to what would be expected, while an upgrade from four stars to five generates a 35% boost, according to a 2001 study by the Atlanta Federal Reserve. The same researchers revisited the topic in 2008 and confirmed that a change in a fund's star rating affects flows. Fund companies also leverage their star ratings, touting them in advertisements and promotional material.
The current star system is much more cut-and-dried than the new system will be. Currently, the star rating is based on risk-adjusted three, five, and ten-year returns, and any fund that's been around for three years or more gets one. That rating is automatically updated every month as the company crunches the numbers on the latest performance data. Because the new system incorporates more opinion and analysis, Morningstar hopes it will be a better predictor of future performance than the current star system is. "The star rating is like the grade you got in school," says Don Phillips, Morningstar's president of fund research: It tells you how a fund did last quarter, but doesn't predict future success.
The official ratings won't be out until this fall, but SmartMoney, with the help of Morningstar's Russell Kinnell, Director of Fund Research, and Phillips, took an early look at some funds who may benefit from the new ratings and some who might lose out.
The biggest winners in the new system will be funds with talented managers whose recent performance has slipped. "There are times when quality managers will be out of step with the market," Phillips notes. Hopefully, the new Analyst Ratings will encourage investors to stick with a good fund through tough times, he says. Here are some funds that might get a boost:
Clipper, a $1.2 billion large-cap blend fund that's currently stuck with a two-star rating, has nonetheless been an Analyst Pick since 2002. This is a concentrated fund that suffered in the 2008 market downturn, but prior to 2008 it was a winner: From 2001 through the end of 2007, it beat its category by 12 percentage points. The fund hasn't fully caught up from its 2008 losses, but it has outperformed its category since March 2009. At 0.76%, expenses are low, and the fund's managers have their own money at stake.
Dodge & Cox Global Stock (DODWx) gets only two stars, but that's partly because it was launched in May 2008, and the company's funds struggled in the market downturn, Kinnel says. But the firm's long-term record is excellent, and the team managing this fund boasts an average 19 years of experience at the firm. Expenses are low (0.69%), and Morningstar likes the fund company's long-term view, clear communication with shareholders, and history free of regulatory issues.
Harbor Commodity Real Return launched in September of 2008, so it doesn't yet have a three-year track record or a Morningstar rating. The $298.5 million fund is an analyst pick for its performance so far beating its category by nearly 8 percentage points over the past year and for manager Mihir Worah's track record on another fund, the PIMCO Commodity Real Return fund, which he runs using a similar strategy.
Vanguard Precious Metals & Mining is another two-star fund, having fallen significantly behind its category in 2008, but low expenses (0.27%) and experienced management have made it an analyst pick. It's volatile, but less so than other precious metals funds. It has lagged its peers since the market started to turn around post-2008, but over the seven-year period ending in mid-2008, it beat its category average by 50 percentage points total. Vanguard's highly respected corporate culture should also help this $5.5 billion fund get a strong Analyst Rating.
Funds with strong records but high expenses will likely suffer under the new system, which will place more emphasis on cost, Phillips says. Here are some funds that might see their stars dimmed:
Kinetics Internet No Load fund currently has a four-star overall rating, and a five-star rating for the past three years. It's beaten the mid-cap growth category by nearly 7 percentage points in the last three years, and by 3 percentage points in the past 5 years. But it's a Morningstar Analyst Pan for what the research firm describes as an "outdated strategy" that focuses on firms participating in the growth of the internet, a portfolio too heavily weighted to a few sectors, and a 1.9% expense ratio that's high compared to other no-load funds. Kinetics Asset Management declined to comment.
Fidelity Canada gets a five-star rating. It beat the foreign large-cap blend category by 5 percentage points over the past 5 years, and by nearly 8 percentage points over the past 10 years. "Not that it's a bad fund," Morningstar's Kinnel says, "but it's not something an investor really needs, a Canada-focused fund." It has a strong record because Canada is a natural resource producer, and its currency has appreciated as well, but doubts about whether those trends will continue are likely to leave this fund with a "middle of the pack" Analyst Rating, Kinnel says. A spokeswoman for Fidelity says that Doug Lober, the fund's portfolio manager, has 25 years of experience with the firm and a deep knowledge of Canadian markets in particular, and notes that the fund has beaten 82%, 96%, and 100% of its Morningstar peers over 1-, 3- and 5-year periods.
Templeton China World is another five-star fund Morningstar analysts aren't completely sold on. Sure, performance has been strong, beating the China region category over the last one-, three-, and five-year periods; $10,000 invested in the fund in 2001 would be worth almost $50,000 today. But a hefty 2% expense ratio dampens Morningstar analysts' enthusiasm. "Not that it's a terrible fund, but it's relatively costly, and that's probably hard to justify," Kinnel says. A spokeswoman for Franklin Templeton says the fund cut its management fee in May, which, she says, should bring the expense ratio closer to the median for its Morningstar category.
Fidelity OTC gets five stars, and it's beaten the large-cap growth category consistently over the last decade, including finishing a stunning 26.6 percentage points ahead of its peers in 2009. At 1.04%, expenses are average for the category. But the fund's unusual mandate of investing 80% of assets in stocks traded on the Nasdaq exchange or an over-the-counter market makes it tough to see it getting a triple-A analyst rating, Kinnel says. "Not that it's going to get a negative rating, but it doesn't sound like a compelling case to me," he says. Plus, the portfolio manager has only been on board since 2009, and while he's done a good job so far, "this is the first diversified fund he's run," Kinnel notes. The firm's spokeswoman says the fund's portfolio manager, Gavin Baker, has 12 years of experience with the firm and has particular expertise in media, telecom, and utilities stocks, sectors that are heavily represented in the fund's benchmark.