News, Vision & Voice for the Advisory Community


Morningstar explains its new forward-looking rating system -- and tosses in some hot fund picks for good measure

The Chicago-based firm adds Gold, Silver, Bronze, Neutral and Negative ratings to its rear-view-facing constellation of stars

Wednesday, December 21, 2011 – 12:46 PM by Lisa Shidler
no description available
Russel Kinnel: Sometimes there's just some key information that's not being considered in the star ratings.

It’s quite possible some RIAs will be perplexed when they look up a fund on Morningstar and discover that it was given a ho-hum two-star rating but that same fund snagged an impressive Gold rating from company’s new Analyst Rating system.

The reason for the mixed ratings is simply that Chicago-based Morningstar, Inc. analysts are looking at different criteria when they rate the fund, explains Russel Kinnel, Morningstar’s director of funds. Kinnel was host of a webcast on Tuesday explaining how the two rating systems work.

Morningstar’s longstanding five-star system is still rearview-facing. Its new Analyst Rating system, which uses Gold, Silver, Bronze, Neutral or Negative, is more subjective and forward-looking. First announced in June, the system was launched last month and is based on a number of criteria, including a manager’s background. See: Morningstar’s Mansueto views next horizon: rating RIAs.


“Most of the time [the two rating systems] are in sync, but not always,” Kinnel says, explaining why a fund might get top ratings in one system but a poor grade in the other. “We have some two-star Gold rated funds. There are some funds where the trailing three-, five- or 10-year performance just doesn’t capture the whole picture.”

For instance, he points out that the Clipper Fund (CFIMX) received a two-star rating because it is a relatively new and doesn’t have the historical track-record for the star rating system. But the fund earned a Gold in Analyst Rating because of the firm’s process and other criteria that analysts found admirable.

“Sometimes, there’s just some key information that’s not being considered in the star ratings and that’s why we feel the Analyst Rating addresses that issue,” Kinnel says.

Objects in the mirror…

Still, one industry analyst predicts the new system certainly will be baffling to advisors and investors alike.

“There’s going to be some confusion,” says Burton Greenwald, a Philadelphia-based mutual fund consultant. “The original system was a rearview mirror looking backwards and they recognized that had serious problems. Now, they’re trying to make future predictions and that can be just as hazardous as trying to make investment decisions based on past performance. They recognize they had some flaws before, but I don’t think this is the answer.”

Skewing up

Morningstar has been analyzing funds since 1996 and has 100 analysts across the globe picking funds. So far, the company has ranked 400 funds under the new Analyst Rating system and aims to hit 1,500 by the end of next year.

Kinnel acknowledges that the Analyst Ratings right now tend to have more top ratings because the firm purposefully chose some of the top-performing funds for its first ranking under the new system.

“The list skews toward Gold and it’s not because we’re in the industry’s pocket,” he says. “It’s because we started with many of the best funds.”

But he says so far there are more than 20 funds already posted with negative rankings.

“We’re not afraid to knock a fund when appropriate,” Kinnel says. “We run these ratings through a committee with gray-haired people to give them added perspective. We want to make sure our analysts have done their homework.”

Burrowing down

Kinnel says the Analyst Rating is made up of several components that aren’t always considered in the star rating system. For instance, the Analyst Rating looks closely at fund managers, which also includes the staff surrounding the managers. He says analysts will dive deeply and look at how managers make decisions — if they’re executing a strategy or simply following the crowd.

Analysts also examine the fund’s parent company and consider its culture and whether managers are encouraged to stay long term or if there’s a high turnover. Performance is certainly a factor in the Analyst Rating, Kinnel says, but manager track records and whether they’ve outperformed — and for how many years — are also taken into account.

Wait-and-see stance

Kinnel says that analysts will, in fact, consider a manager’s age when crafting a rating under the Analyst Rating. But what’s really important to Morningstar is whether the fund is training a younger manager under the supervision of an aging manager.

For instance, he says, in cases where fund managers are in their 70s and don’t have rising star managers in place to follow in their footsteps, Morningstar might give a lower Analyst Rating.

Kinnel also says that some funds will end up with a neutral rating simply because Morningstar doesn’t have enough research with which to make judgments, and there may be new managers. The Fidelity Equity-Income II Fund, for example is a good example of a fund that received a neutral ranking because of a relatively new manager.

Hot fund picks for 2012

In addition to delving into the new Analyst Rating system, Kinnel spent some time talking about top areas for advisors and investors to consider in 2012 and beyond.

“I’m looking at funds with characteristics that make them look good. I’m thinking long term, too.”

• Dividend funds. Kinnel says advisors should look for dividend funds with a yield of 2% to 3%, pointing out that if they grow 20% over the next five years that would be a big boost to a client’s income.
• Muni bond funds. Kinnel couldn’t resist taking a dig at Wall Street analyst Meredith Whitney, who went on “60 Minutes” a year ago predicting an ominous outlook for municipal bond markets as he was touting the upside of this sector. The sky isn’t falling on muni bond funds, says Kinnel — quite the opposite: “Meredith Whitney was off by the order of 99 times the actual default rates. Muni bonds are still a good place to be.”
• Emerging markets. There are a number of areas among emerging markets that are still attractive. “Obviously, it’s always going to be volatile and it’s not something you want to make a quarter-holding out of, but 10% to 20% in emerging markets makes a lot of sense,” Kinnel said.
• World stock funds. Kinnel points out that this area typically is overlooked and says investors should consider such funds whose managers have greater flexibility to find the best investments.

H2, Funds to consider

• Sequoia Fund Inc. (SEQUX). Kinnel describes it as one of the best funds with a solid management team and philosophy.
• Pimco EqS Pathfinder Institutional (PTHWX) Kinnel points to an excellent team of managers with Charles Lahr as one of the key managers who has had repeated success.
• Artisan Global Value Investor (ARTGX). Kinnel says this fund has had excellent performance.

Buy the unloved

Kinnel says that some investors and advisors like to purchase funds that are “unloved” or those that have gotten the most outflows. It’s certainly not a scientific approach, but even he acknowledges that sometimes it just works.

“If you invest in areas that are most unpopular, you usually do pretty well,” he says. “We’ve tested it before, and it works. The reason it works is because it’s leading you toward the cheapest asset classes and away from the overhyped asset classes, and that’s not a bad thing to do … not that it’s foolproof.”

• Unloved: Large growth, world stock and mid growth.

• Loved: Emerging markets, world allocation and commodities.

Related Moves

Jeff Mello is latest to join eMoney's talent exodus but CEO Ed O'Brien says it's healthy renewal at a firm that added several hundred people since Fidelity bought it

The ex-Goldman Sachs director of strategy and planning at eMoney joins a growing list of departures exacerbated, sources say, by Fidelity putting a wobbly performance reporting software project -- and staff -- on its plate

February 28, 2020 – 11:09 PM

Pete Giza and Damon Deru go for Holy Grail of portfolio rebalancing with software that shuffles stocks, bonds... and asset classes; Believe it?

The RedBlack and TradeWarrior executives see old systems as 'archaic' yet know that the Black Diamonds, Morningstars, Orions and Tamaracs see rebalancing as a loss leader

June 11, 2019 – 9:49 PM

Mentioned in this article:

Morningstar, Inc.
Top Executive: Joe Mansueto

Elmer Rich III

Elmer Rich III

December 21, 2011 — 4:48 PM

Ah, so a financial services publisher has solved the problem of predicting the future! Likely a Nobel Prize in there somewhere.

“There are approaches to mutual fund prediction that have been documented as being effective.” Please provide independent, peer-reviewed evidence of this claim. Sales and marketing reports are not needed.

If this is such a robust and accessible deliverable, there must be vast amounts of independent (non-commercial) validation.

So if these remarkable (miracle) approaches that predict the future will take 1-2 years to validate whould investor’s money be trusted to them now?

Anthony DuBon

Anthony DuBon

December 21, 2011 — 2:48 PM

Morningstar is clearly taking a risk with the new rating system. They are putting their money where their mouth is. The risk is hedged though. I have not yet seen the word “predict” in any of the many announcement emails and articles, but that is what they are doing. With the focus on subjective evaluation of mutual funds by talented analysts, they will, at the very least, add value through comment and color, which should be helpful to some investors and advisors. The biggest hedge in the Morningstar move is the fact that the accuracy of the system cannot be evaluated now. They are marketing the system incessantly with article after article. But, we won’t know if it works for years.

There are approaches to mutual fund prediction that have been documented as being effective. The web service MutualDecision began to track their recommendations showing some predictive capability. Unfortunately the site went out of business in early 2011. FundReveal has an approach that uses quantitative measurements focused on determining investment decision-making capability has been offering predictive service since its inception in 2009. A retroactive demonstration of the approach shows significant outperformance versus the S&P500 between 2000 and 2010. Full disclosure: I am a member of the FundReveal team. Only time will tell if the new service has predictive capability. We look forward to the evaluations that will be possible in a year or two when the necessary data is available.

Wendy J. Cook

Wendy J. Cook

December 22, 2011 — 12:44 AM

Let’s take a flight of fancy and assume that Morningstar has been able to boldly go (etc.) offering consistently reliable, forward-looking ratings. Then what? It’s not like the insights would be a big secret that a privileged few could cash in on; quite the opposite. So then, once it became widely obvious they were right, wouldn’t everybody start relying on them and piling in to buy the alleged golden eggs and sell the rotten ones (or, for the contrarians, the reverse, but the same basic premise)? Wouldn’t this have to spell the demise of the anomalous goose shortly thereafter, based on the science of expected returns? Thus, even in the best-case scenario that the system were working now, it seems to me it wouldn’t work for long. And how would an investor know when it had stopped working, other than in hindsight? Hello, square one.

RIABiz Directory

The Industry Sourcebook for RIAs

   |    LISTING

RIABiz Directory sponsored by:

Directory Sponsor Logo