Winning a coveted Gold rating from Morningstar's fund analysts will become tougher under newly tightened criteria.
Morningstar is overhauling its system of mutual fund ratings. The initial batch went into effect Oct. 31, with the rest rolling out over the ensuing 12 months. Jeff Ptak, global director of manager research at Morningstar, estimates the number of downgrades will outnumber upgrades by roughly 2-1, with costlier funds facing the most downgrades once the initial rerating of the funds is completed.
Under the old methodology, Morningstar's highly respected analysts haven't been able to consistently pick mutual funds or exchange-traded funds (ETFs) that beat their benchmark index despite years of trying.
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That might change under the new methodology.
Where Morningstar Ratings Came Up Short
Since 2011, Morningstar analysts have awarded Gold, Silver and Bronze ratings to those funds and ETFs judged to be the most likely to top their benchmarks in the coming years. Morningstar also rates some funds as Neutral or Negative. Bronze medals are an expression of confidence, and Silver even more so. Gold medals are the firm's "highest conviction recommendations."
Ptak ran the numbers for each of the five categories over all rolling 60-month periods between July 1, 2002 and March 31, 2019. Over 12-month periods, Gold-rated funds, on average, beat their benchmark indexes by 15 basis points. (A basis point is one one-hundredth of a percent.) But over the past 36- and 60-month periods, Gold-rated funds trailed their Morningstar-assigned benchmark indexes by an average of 15 basis points and 34 basis points, respectively.
These are tiny margins, of course – often less than what an index fund or exchange-traded fund (ETF) would charge in expenses. But Silver and Bronze medalist funds trailed their indexes over all time periods and by healthier margins.
The relatively superior performance of Gold-rated funds is a strong signal to investors that, if you're going to assign much importance to Morningstar's medalists, you'll likely do best by sticking with Gold-rated funds.
The picture isn't completely bleak. All Morningstar medalists – Gold, Silver and Bronze – topped the average fund in their category over 12, 36 and 60 months.
But for investors looking for a way to beat the indexes, outperformance only against other actively managed funds in the same category is cold comfort.
Ptak also looked at how the medalist funds did against their benchmarks on a risk-adjusted basis. Risk-adjusted performance, in this case alpha, is Morningstar's preferred target for judging which funds should be medalists.
Looked at through that lens, Morningstar's medalists were a mixed bag. Gold medalist funds, on average, beat their indexes by small margins over 12, 36 and 60 months. Silver medalist funds topped their indexes over the past 12 months, but essentially tied across 36 and 60 months. Bronze medalists trailed across all three time periods.
"Our performance looks fine through a number of lenses," Ptak says. "But it's fair to say that, through our performance measurement, we saw an opportunity to fortify our methodology in a few respects."
The Changes
Morningstar's medalist ratings have always counted fund expenses as one of the most important (if not the most important) factors in rating a fund. The lower a fund's expense ratio, the better chance it has of outperforming its benchmark.
However, as one enhancement to their methodology, expenses will be even more critical.
Morningstar also will end the practice of awarding the same rating to every share class of a fund regardless of that share class's expense ratio. For instance, under the old criteria, Pimco Total Return Institutional (PTTRX) was a Gold medalist with an expense ratio of 0.71%, or $71 annually on a $10,000 investment. But so was Pimco Total Return C (PTTCX), even though it charged 1.8% – more than double the Institutional shares.
Ptak says this will account for many of the ratings changes.
Most changes, Ptak says, will be one-rung downgrades. A fund now rated Gold might well be rated Silver once the changes are implemented. Many low-cost index funds, meanwhile, are likely to get upgrades given the increased focus on fund expense ratios.
What's more, Morningstar until now has rated funds' expense ratios based on the average expense ratio in its category. Funds that charged lower-than-average expense ratios within their category were given positive ratings for low fees. In the future, Morningstar analysts will assess the value it offers before fees – simply being the cheapest won't be enough.
Actively managed funds will have a significantly higher bar to clear than they currently do.
"For an active fund to earn a Gold, Silver, or Bronze rating, our research must convince us that the fund can beat both a relevant index and peer group average after fees and adjusting for risk," Ptak writes in an article explaining some of the changes (paywall).
This bar will be more difficult to scale, which means it'll be more difficult for funds to become medalists. But whether this leads to an overall improvement to its medalist ratings' predictive powers remains to be seen.
Ptak says part of the problem for Morningstar analysts has been the relentless bull market, which increasingly has been led by large growth stocks, especially mega-cap tech stocks. Funds that deviate even a little from their growth-stock category have been punished by the market.
In addition, given that Morningstar seeks to award medals based on estimated risk-adjusted performance relative to a benchmark, a long period without a bear market has hampered their picks.
Morningstar has been slammed unfairly for years for its star ratings, which were never meant to be predictive. Star ratings are quantitative measures designed to measure funds' trailing risk-adjusted performance. Like Sortino ratios, the Morningstar star rating only penalizes a fund for downside volatility. Most risk measures penalize all volatility.
The medal rankings, however, displayed some real weaknesses. I'm dismayed that my favorite fund picker's medalists haven't done better against their indexes. The past results are clearly yet another win for index funds.
But I'm betting that the newly revamped methodology will finally enable Morningstar to consistently pick actively managed funds that beat their index.
Steve Goldberg is an adviser in the Washington, D.C., area.
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