Four months after news broke that changes were coming, the Morningstar Analyst Rating system for funds is now in place with a new methodology.
The new system gives more weight to fees and sets the bar higher for for active funds, while shifting how Morningstar assigns ratings to fund share classes to account for specific fees being levied on each share class. (See above chart.)
The changes, which had been in the works for some time, impact the gold, silver, bronze, neutral and negative ratings (rolled out in 2011) but not the star ratings.
“We’ve enhanced the methodology that underpins the Analyst Rating and rated 123 funds under this updated approach; we’ll update the rest of our coverage universe over the next 11 months or so,” according to Jeffrey Ptak, the research firm’s global director of Manager Research.
“Among the initial batch of rated funds, downgrades outnumbered upgrades two to one, with costly funds downgraded four times as often as inexpensive funds,” Ptak, CFA, explained in a blog.
In the past, Morningstar ranked a fund’s price tag vs. those of its peer group. Now, the research group is “simply subtracting a fund’s expenses from our estimate of how much value it can add before fees. If there’s nothing left for investors, then we won’t recommend the fund,” he wrote.
Though the research group used to give the same rating for all share classes of a fund, it’s moved to tailor ratings to each share class by taking its specific fees into account. “Thus, costlier share classes see lower ratings in some situations,” according to Ptak.
Active vs. Passive
To earn Gold, Silver and Bronze ratings, Morningstar researchers must believe “that an active fund can beat its benchmark index after fees, adjusted for risk,” he points out.
In the past, it might have recommended an active fund that could outperform “its average peer but not a costless index, net of fees and after adjusting for risk,” Ptak said. “Now we won’t recommend an active fund if it can’t clear both a relevant benchmark index and peer group average.”
Morningstar shared a before-and-after look of one fund, MFS Utilities. This is the fund’s Analyst Ratings and pillar ratings using the old methodology:
Here’s the new approach, which has two fewer pillar ratings, a different pillar ratings scale and varied Analyst Ratings for the fund’s nine share classes — reflecting the different fees the share classes levy.
“When we accounted for each share class’ specific fees as part of our analysis, we concluded that these more expensive share classes wouldn’t add value for investors after adjusting for risk. That explains why they received Neutral ratings while the fund’s less costly share classes got Bronze ratings,” Ptak explained.