Morningstar’s New Fund Rating System: An Improvement?

Dec 2011

Morningstar made a big splash this week announcing a new fund rating service: Global Analyst Ratings. I believe it’s an attempt to improve upon their famous “Star” rating system they have been using to rate funds for more than two decades. Their “Star” rating system was revolutionary for Morningstar and also for the fund industry. Essentially, it put Morningstar on the map as one of the most credible resources for mutual fund investing.

Morningstar hopes their new rating system becomes as popular as the stars. I have always believed their star rating system was somewhat flawed, even though their analysts’ do good work. The main flaw I see in their star rating system is the backward review of the funds. They never had much performance predictability even though Morningstar believed the funds with the most stars were the best funds. This has not always been true. The stars can change periodically, going from good to average or vice versa. It’s kind of like an equity analyst that rates a stock a “buy” one month, and then a “hold” the next month. There is no consistency and a mix of confusion.

As an investment management firm that uses primarily no-load mutual funds as its primary investment vehicle, it is extremely critical to understand how a fund achieves its performance, and not just look at its raw performance, or to just find out how many “Stars” Morningstar has ascribed to it.

I actually think their new fund rating system may be more beneficial than their star system for do-it-yourself investors because it will provide more qualitative analysis with respect to three key areas: people, process, and parent. The people aspect is very important because you are investing not only with fund managers, but with an entire team including analysts and other support staff that helps fund managers achieve success. The process is also critical, and one that our firm spends a lot of time assessing in terms of how management selects, monitors, and manages investments on a day to day basis, whether they are stocks or bonds, or any other type of security.

Having a better understanding of how a manager may perform during different types of markets helps in the long run. It may prevent an investor from selling a fund when they should be buying more or holding steady. And just how people are important, so is the parent company. Through the years, I have seen so many mutual fund firms get acquired or spun off, and then performance struggles because of management turnover. It is important to invest with a fund firm that has a strong and dedicated parent that will provide the necessary resources to keep their funds competitive.

In the end, Morningstar’s attempt to rate funds based upon the criterion above may open the door to more debate about whether their new rating system will actually work in the long run. I’m sure they will make adjustments over time to improve their analysis, but it is a step in the right direction.


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