For Financial Advisor and Current Client Use Only What s in a Star Rating? How we look beyond performance to evaluate a fund F Jeff Ptak, CFA President & Chief Investment Officer Morningstar Investment Services Morningstar Investment Services Commentary Advisors and clients often ask us why we own funds that don t garner a four- or five-star rating from our parent company, Morningstar, Inc. In selecting funds, we take a number of factors into account looking beyond what a star rating might reveal. Below, we review what the star rating actually measures, tally-up the distribution of ratings across the funds we invest in, and explain why we d own lower-rated or unrated funds to begin with. Executive Summary The star rating for funds is a backward-looking, quantitative system that ranks funds based on their past risk-adjusted returns. The star rating can be a starting point for research but isn t meant to be predictive. In choosing funds for our models, we have to evaluate attributes that are likelier to have a stronger bearing on future performance, including qualitative factors like process, people, parent, and price. Therefore, in certain situations i.e., where a fund is an ill-fit for its category, experiences fleeting performance woes, or boasts a longer record than meets the eye we might invest in lower-rated or unrated funds that we believe have bright prospects. What is the Star Rating? To review, the Morningstar, Inc. rating for funds ( the star rating ) is a quantitatively-driven rating of a mutual fund s past risk-adjusted performance versus its category peers. Essentially, Morningstar tallies up a fund s trailing three, five, and ten-year returns, adjusts those returns to account for the risk the fund courted along the way, and then ranks that fund s risk-adjusted returns against those of other funds that inhabited the same category.
The ratings follow a bell-shaped curve: Top 10%: Five-stars Next 22.5%: Four-stars Next 35%: Three-stars Next 22.5%: Two-stars Bottom 10%: One-star The star rating methodology is entirely backwards-looking and quantitative, entailing no judgment or subjectivity. It s intended to be a starting point for research, a tool that investors can use in sifting through large numbers of funds in whittling the universe down to a more-manageable size. Our Holdings Let s cut to the chase below is the ratings distribution of the mutual funds that we own in the mutual-fund portfolios that we manage. (We ve limited it to the Bank of New York Mellon custodial version of those portfolios, as that s where the preponderance of our mutual-fund assets resides.) Star Rating data from Morningstar, Inc. as of 6/30/2014 Morningstar Investment Services mutual fund portfolio data as of 6/30/2014 As you can see, four- and five-star funds are well represented in our models, accounting for more than 80% of our assets in mutual funds. But that also means we invest nearly 20% of assets in unrated or lower-rated funds, inviting the question why we d invest in such funds to begin with. The Fault in Our Stars The short-answer is that past performance, which is the primary driver behind the starrating, is not predictive. While it s true that the star rating might point you in the direction of funds that boast durable advantages like low expenses, there s no guarantee of that.
What s more, because performance has a tendency to revert to the average, it means today s heroes could become tomorrow s goats and vice versa. Given this, we look beyond past performance in evaluating a fund s merits. To illustrate, below we compare the factors that we consider in conducting qualitative reviews of funds to the factors that the star rating weighs: Star-Rating MIS Qualitative Review Performance 100% 25% Process 0% 25% People 0% 20% Price 0% 15% Parent 0% 15% As you can see, we consider not just performance but also other factors like the prudence and repeatability of the investment process ( process ), the talent and commitment of the investment team ( people ), the competitiveness of fees ( price ), and the shareholderfriendliness of the fund-company concerned ( parent ). The star-rating, on the other hand, is based entirely on past performance. Why not just rely on past performance alone? As mentioned, past performance is not predictive. You ve got to dig deeper. And so that s why we look at these other factors, which we believe are more-telling indicators of how a fund might fare in the future. Of course, that doesn t mean we have an aversion to funds that have been successful. Indeed, as shown earlier, many of the funds that we use in our models have received fouror five-star ratings on the strength of their standout past performance. But in those instances we continue to invest in the funds not simply because they ve done well but because we think they ll do well in the future. We gain that confidence by focusing on those other attributes process, people, price, and parent. Where We Differ The question that remains is why we d retain confidence in a fund whose performance doesn t stack-up especially well against category peers, or that lacks a full track record. While the circumstances can vary, they tend to coalesce around a few recurring themes: Ill-fitting category: Remember that the star rating turns on a fund s past riskadjusted returns versus its category peers. Therefore, if a fund is an ill-fit for its category, that s likely to result in apples-to-oranges comparisons that aren t necessarily telling. This can take a variety of forms, from a strategy that practices a style of investing that s unusual even by the standards of its category to a fund that
tends to take on far less risk (and therefore offers less potential reward, especially over shorter periods) than the norm for its peer group. Fleeting performance woes: The star rating is based on a fund s trailing three-, five-, and ten-year risk-adjusted returns. However, the three-year number tends to dominate, as it s present in all three trailing time periods (it s 100% off the three-year record, 60% of the five-year figure, and 30% of the ten-year number). Even the most worthy funds experience rough patches from time to time and that will dent their star rating when it happens. But we try to be realists about the cyclical nature of fund performance success tends to beget disappointment followed by success, and so forth and therefore invest for the long haul. That, in turn, explains why we are willing to look past a temporarily lackluster star-rating. Newer fund, proven strategy: In some instances, we ll find a newer fund that s helmed by an experienced team plying a strategy they ve been successfully running for years. For example, a money manager that has only been offering the strategy to high net-worth clients via separately-managed accounts. In this scenario, the fund won t possess a full track record and therefore won t qualify for a star rating(to be eligible, a fund must have at least a three-year record). But we don t think that really matters provided that it s the same successful strategy and team as before. Good manager, bad record: In general, fund companies usually put lower-rated funds out of their misery by liquidating them or merging them into other funds. But every once in a while they ll leave the fund alone and replace the manager who amassed that crummy track record with someone who is far more proven and experienced. Situations like these don t arise too often but we get pretty interested because the low-rated fund concerned usually isn t burdened by a heavy asset-base at the time the new, proven manager takes the helm. That means he or she can implement the strategy more nimbly than might otherwise be possible. Another Way to Look at It It s worth noting that the star rating for funds isn t the only type of fund rating that Morningstar, Inc. puts out. There s also the companion Morningstar analyst rating for funds, which follows a gold, silver, bronze, neutral, and negative scale. The analyst rating for funds is similar to the approach that we follow it considers both qualitative and quantitative attributes. Unlike the quantitatively-driven star-rating, the analyst rating is subjective, as it s awarded by a fund analyst on the Morningstar, Inc. fund research team. It also doesn t follow a normal distribution, as analyst ratings can cluster in any particular ratings rung.
The analyst-ratings are forward looking, denoting the analysts conviction in a fund s ability to beat a relevant category average. Gold -rated funds are those the analysts have the highest conviction will beat the median peer while negative -rated funds are those that the analysts believe investors should avoid due to poor future prospects. Given that the analysts have assigned analyst ratings to most of the funds that we hold in our mutual-fund portfolios, it s also worth taking a look at the distribution of analyst ratings across our assets in mutual funds: Star Ratings were pulled from Morningstar, Inc. as of 6/30/2014 MIS mutual fund portfolio data was pulled as of 6/30/2014 As shown in the chart, we re investing nearly 80% of assets in funds that have earned at least a bronze rating. In other words, we re investing the clear majority of assets in funds that Morningstar, Inc. s analysts believe will, at worst, beat the relevant category average in the future. Taking the two ratings schemes together the star rating and the analyst rating for funds we can look at the distribution of our assets through a different lens, shown below. Gold Silver Bronze Neutral Negative Unrated Total 5 13.8% 3.6% - 6.7% - - 24.0% 4 31.6% 11.1% 8.2% 0.5% - 5.8% 57.2% 3 0.7% 2.7% 2.5% - - 3.1% 9.0% 2-1.3% 1.6% 1.6% - 0.1% 4.6% 1 - - - - - 2.4% 2.4% Unrated - - 1.5% - - 1.2% 2.7% Total 46.1% 18.7% 13.8% 8.7% - 12.6% 100.0% Conclusion The star rating is a quantitatively-driven rankings scheme that only considers a fund s past risk-adjusted performance versus category peers. However, in managing mutual-fund
models for clients, we re not investing through the rear-view mirror. Rather, we must consider other, qualitative factors that we think have a stronger bearing on future performance, such as process, people, parent, and price. That broader focus can give rise to situations that find us investing in lower-rated or unrated funds. These situations are likeliest to arise when a fund is an ill-fit for its category, has suffered a temporary bout of underperformance, or is new to the scene (though the underlying strategy and manager aren t).
For Financial Advisor and Current Client Use Only The information, data, analyses and opinions presented herein do not constitute investment advice; are provided solely for informational purposes and therefore are not an offer to buy or sell a security; and are not warranted to be correct, complete or accurate. The opinions expressed are as of the date written and are subject to change without notice. Except as otherwise required by law, Morningstar Investment Services shall not be responsible for any trading decisions, damages or other losses resulting from, or related to, the information, data, analyses or opinions or their use. The information contained herein is the proprietary property of Morningstar Investment Services and may not be reproduced, in whole or in part, or used in any manner, without the prior written consent of Morningstar Investment Services. The indices noted are unmanaged and cannot be directly invested in. Individual index performance is provided as a reference only. Since indices and/or composition levels may change over time, actual return and risk characteristics may be higher or lower than those presented. Although index performance data is gathered from reliable sources, Morningstar Investment Services cannot guarantee its accuracy, completeness or reliability. Morningstar, Inc. is the parent company of Morningstar Investment Services. Morningstar Analyst Rating The Morningstar Analyst Rating is not a credit or risk rating. It is a subjective evaluation performed by the mutual fund analysts of Morningstar, Inc. Morningstar evaluates funds based on five key pillars, which are process, performance, people, parent, and price. Morningstar's analysts use this five pillar evaluation to identify funds they believe are more likely to outperform over the long term on a risk-adjusted basis. Analysts consider quantitative and qualitative factors in their research, and the weighting of each pillar may vary. The Analyst Rating ultimately reflects the analyst's overall assessment and is overseen by Morningstar's Analyst Rating Committee. The approach serves not as a formula but as a framework to ensure consistency across Morningstar's global coverage universe. The Analyst Rating scale ranges from Gold to Negative, with Gold being the highest rating and Negative being the lowest rating. A fund with a Gold rating distinguishes itself across the five pillars and has garnered the analysts' highest level of conviction. A fund with a Silver rating has notable advantages across several, but perhaps not all, of the five pillars-strengths that give the analysts a high level of conviction. A Bronze-rated fund has advantages that outweigh the disadvantages across the five pillars, with sufficient level of analyst conviction to warrant a positive rating. A fund with a Neutral rating isn't seriously flawed across the five pillars, nor does it distinguish itself very positively. A Negative rated fund is flawed in at least one if not more pillars and is considered an inferior offering to its peers. Analyst Ratings are reevaluated at least every 14 months. For more detailed information about Morningstar's Analyst Rating, including its methodology, please go to: http://corporate.morningstar.com/us/documents/methodologydocuments/analystratingforfundsmethodology.pdf. The Morningstar Analyst Rating should not be used as the sole basis in evaluating a mutual fund. Morningstar Analyst Ratings are based on Morningstar's current expectations about future events; therefore, in no way does Morningstar represent ratings as a guarantee nor should they be viewed by an investor as such. Morningstar Analyst Ratings involve unknown risks and uncertainties which may cause Morningstar's expectations not to occur or to differ significantly from what they expected. Morningstar Star Rating The Morningstar Rating is calculated for funds with at least a three-year history. It is calculated based on a Morningstar Risk-Adjusted Return measure that accounts for variation in a fund's monthly performance, placing more emphasis on downward variations and rewarding consistent performance. The top 10% of funds in each category receive 5 stars, the next 22.5% receive 4 stars, the next 35% receive 3 stars, the next 22.5% receive 2 stars and the bottom 10% receive 1 star. The Overall Morningstar Rating for a mutual fund is derived from a weighted average of the performance figures associated with its three-, five and 10-year (if applicable) Morningstar Rating metrics. Please note that some Morningstar proprietary calculations, including the Morningstar Rating, may be calculated based on adjusted historical returns (pre-inception returns). If the extended performance rating is in effect, the "stars" are represented as unshaded stars. For each mutual fund with at least a three-year history, Morningstar calculates a Morningstar Rating based on a Morningstar Risk-Adjusted Return measure that accounts for variation in a fund's adjusted monthly performance, placing more emphasis on downward variations and rewarding consistent performance. The top 10% of funds in each category receive 5 stars, the next 22.5% receive 4 stars, the next 35% receive 3 stars, the next 22.5% receive 2 stars and the bottom 10% receive 1 star. This investment's independent Morningstar Rating metric is then compared against the open-end mutual fund universe's actual performance breakpoints to determine its extended performance rating. The Overall Morningstar Rating for a mutual fund is derived from a weighted average of the actual performance figures associated with its three-, five- and 10-year (if applicable) Morningstar Rating metrics.