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How Morningstar’s New Ratings Reality Will Affect Funds, ETFs

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With changes to its analyst rating methodology starting Oct. 31, Morningstar wanted to clarify how many mutual funds and ETFs it follows actually would be affected — for good or bad. Running funds through the new methodology, and comparing these to the existing rating system, Morningstar determined a rough loser/winner percentage.

Bear in mind the new system includes fees charged by the fund or ETF in its calculation. Right off the bat, funds with a higher fee structure would be downgraded.

The change will directly deduct a strategy’s expenses from the analysts’ estimate of its potential value-add before fees, which will “see what the strategy will give before fees,” said Jeffrey Ptak, global director manager research, in an earlier conference call. One reason is to make the system more “relevant to key decisions,” that is, to stay with active or go passive, he added.

Here are some of the key findings of Ptak’s most recent pro forma analysis:

  • About 43% of funds and ETFs will see a rating change — many due to the fee inclusion.
  • By a 2-to-1 ratio, downgrades will outnumber upgrades.
  • Active funds would be more affected to the downside than index funds, which would largely maintain performance. Morningstar states this is mainly because the new methodology “emphasizes low cost, which is a trait the index funds [Morningstar] covers often boast.”
  • The ratings change would be a “one-rung” difference for those funds currently rated silver (27% of all changes), bronze (45%) and neutral (17%).
  • Only about 26% of funds with above-average or high fees would receive a gold, silver or bronze rating, compared with about 50% of those rated today.
  • With the new methodology, Morningstar doesn’t expect more frequent changes as the current system.

Ptak also noted that these results are subject to change as analysts re-evaluate funds.

The first subset of the analyst ratings universe to be rerated staring Oct. 31, with a rollout over the next 11 to 12 months, Ptak stated.

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