Morningstar to Introduce New ‘Forward-Looking’ Rating System

Analyst system meant to supplement, not replace, traditional ‘star’ rating

Don Phillips, Morningstar’s president of research, announced a new “forward-lookinganalyst rating system at the company’s annual advisor conference on Thursday.

According to Phillips, the new system will be based on analysts’ convictions about a fund’s ability to outperform its peer group and relevant benchmarks on a risk-adjusted basis. The company plans to launch the new ratings and research reports in the fourth quarter.

"While the star system has traditionally been a grade that the fund and the manager receive based on past performance, the new system will be more of more of an ‘aptitude test,’ and based on how the analyst perceives any investments, news or management changes will affect performance,” Phillips said.  “The new ratings will not replace the star ratings, and the existing star methodology will not change.”

Morningstar will not charge fund firms to be rated, and its decision to rate and report on a specific fund is made solely by the analyst team based on factors such as investor interest and asset size. In the United States, the new ratings and research reports will replace the company’s “Analyst Picks and Pans.

The new ratings will be assigned as follows—AAA, AA, A, Neutral, or Negative. According to Phillips, analysts will arrive at a rating through an evaluation of five key “pillars” Morningstar believes are crucial to predicting the future success of a fund: people, process, parent, performance and price. If a fund receives a positive rating of AAA, AA, or A, it means Morningstar analysts think highly of the fund and expect it to outperform its peer group and/or relevant benchmark on a risk-adjusted basis over a full market cycle of at least five years.

The ratings scale is as follows:

Positive Ratings:

- AAA: Best-of-breed fund that distinguishes itself across the five pillars and has garnered the analysts’ highest level of conviction;
- AA: Fund with notable advantages across several, but perhaps not all, of the five pillars—strengths that give the analysts a high level of conviction;
- A: Fund with advantages that outweigh any disadvantages across the five pillars, with sufficient level of analyst conviction to warrant a positive rating;

Neutral Ratings: Fund that isn’t likely to deliver standout returns, but also isn’t likely to significantly underperform; and
Negative Ratings: Fund with at least one flaw that is likely to significantly hamper future performance, and is considered an inferior offering to its peers.

In addition, Morningstar plans to adjust its methodology for its stewardship grades in the United States. Later this year, Morningstar will begin to replace the individual fund grades with parent-level stewardship grades using an A-F grading scale for more than 20 fund firms, and aims to complete the full shift to the new methodology in 2012. The parent-level stewardship grades will be part of the parent pillar in the new rating. Morningstar’s analysis of stewardship began in 2004, designed to help investors research and identify fund managers and companies that do a good job of serving fund shareholders’ interests.

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