Are you one of the many investors who use Morningstar, Inc.’s rating system to research investments? If so, we have news for you. The firm is making major changes designed to benefit investors and these modifications could impact how your favorite funds are scored.
Morningstar says the rating changes for mutual funds, exchange-traded funds (ETFs), and other managed investments:
- Will provide investors with more accurate predictions about fund behavior.
- Will give more weight to fees and change ratings for roughly 43% of mutual and ETF funds. Rating downgrades will outnumber upgrades by two-to-one.
- Will leave Morningstar’s rating scale unchanged as Gold, Silver, Bronze, Neutral, and Negative.
- Will affect both the Analyst Rating, which is determined by research analysts and the Quantitative Rating, which is calculated by computer-based algorithms.
- Will roll out changes to Analyst Ratings from the start date—October 31, 2019—and continue over about 12 months. Morningstar updated the Quantitative Ratings en masse in November 2019.
Value to Investors Drives Changes
Here are the three fundamental changes to the Analyst Rating, which will be algorithmically mimicked by the Quantitative Rating:
- Places more weight on fees. Morningstar previously analyzed one representative share class for each fund, then applied the rating for that share class to all share classes in the fund, regardless of their fees. Going forward, the framework will rate each share class separately and account for fee differences.
- Assesses costs in terms of value. Under the old methodology, Morningstar evaluated a fund’s fees by comparing its expense ratio with that of other funds in its peer group. The new formula compares a fund’s costs with the value it can deliver to investors before fees. According to Morningstar’s Jeffrey Ptak, “It won’t suffice to be the cheapest of an expensive lot. What will matter is whether fees are low enough to leave some value for investors.”
- The new methodology will set a higher bar for active funds. In the past, a fund could earn a Gold, Silver, or Bronze rating by beating a relevant index or a peer group average after fees and adjusting for risk. Now a fund will have to beat both.
- Refocuses to be more predictive and easier to understand. The new ratings will now focus on what Morningstar calls the three most predictive of its former five-pillar schemes:
- People Pillar – Managers, analysts, and traders who work with a fund. The analysis includes its expertise and demonstrated skill.
- Process Pillar – Competitive advantages of fund strategies.
- Parent Pillar – The firm behind a fund, including manager turnover, investment culture, quality of research, and ethics.
- The former Performance Pillar is now absorbed into these three categories. The old Price Pillar is expressed through an analysis of fees and costs.
Morningstar Predicts More Downs than Ups as Fees Take Center Stage
If investors can expect a more predictive, easier-to-use investment road map, what effect will Morningstar’s changes have on fund ratings? The firm assessed potential impact by applying systems changes to funds and EFTs with the following results:
- About 43% of funds will see a rating change, mainly because Morningstar now tailors ratings to each share class by taking fee differences into account.
- Rating downgrades will outnumber upgrades by roughly two-to-one.
- The percentage of active funds that are rated Gold, Silver, or Bronze will fall. Share classes that embed advice and sales fees will get more downgrades than upgrades.
- The percentage of index funds (funds that match or track a market index) that earn Gold, Silver, or Bronze ratings will rise.
- About 26% of funds with above-average or high fees will receive a Gold, Silver, or Bronze rating compared with 50% under the old methodology.
- Once the updated systems are in place, Morningstar does not expect more frequent rate changes.
Curious how Morningstar’s methodology may affect your current portfolio or future investments? Our team at FJY Financial can explain the changes and discuss our team’s own due diligence process for evaluating investment decisions to benefit our clients’ financial strategies.