A few of our readers are rather piqued. The reason being that some of Morningstar’s forward-looking analyst ratings run counter to the fund’s near term performance.
Let me explain. Our equity analyst recently revisited some of his ratings.
In the small/mid-cap category,
HDFC Mid-Cap Opportunities has been upgraded from Silver to Gold while
DSP BlackRock Small and Midcap retains its Silver rating.
In the large-cap space,
DSP BlackRock Top 100 Equity,
DSP BlackRock Equity and
HDFC Equity have all been reiterated their Gold rating and
HDFC Growth its Silver rating.
What makes this worth mentioning is the fact that none of the above funds have put up an impressive 1-year performance and are far from 2013 chart toppers. Which begs the question as to why their ratings are still strong. But just as recent outperformance of certain funds is not an automatic entitlement to higher ratings, below-average returns need not shake Morningstar analysts’ confidence in some funds.
What the rating tells you
When the ratings were launched, Don Phillips, Morningstar’s president of fund research, explained that the star ratings are an “achievement test” while the analyst ratings are more of an “aptitude test”.
The star rating is a backward-looking measure that looks at how a fund has performed over the long haul on a risk-adjusted basis versus its peers. The analyst rating pulls together the entire picture about a fund. It is a qualitative and forward-looking view on the conviction of the analyst as to whether the fund is a quality offering or not, irrespective of how the short-term returns have panned out.
On the positive end of the spectrum, we have Gold, Silver and Bronze. If the analyst believes that the fund has sufficient competitive advantages to outperform over the long term on a risk-adjusted basis, such a rating is assigned.
The differences between Gold, Silver, and Bronze signal the level of conviction regarding the full range of the fund's capabilities. Silver and Bronze funds have a very good chance of outperforming, but the analyst cannot give them a clean chit for whatever reason--it might be a management team that's proven but still has to showcase how they can do in different market environments. They would still be rated positively if there is a good chance of outperformance. This range allows us to signal to investors between the positives.
There are funds that we think don't have a clear advantage or disadvantage, and those funds would land in Neutral.
Negative is where we think that a fund has a true disadvantage, and it's going to impede its abilities to outperform in the future.
How you should use the Analyst Ratings
Don’t fixate on how your fund performed relative to its peers over the short term or in one single calendar year. What must matter most to an investor is how the fund has performed over the long term over various market cycles. Let’s face it, even the best of funds don't deliver top-tier performance each and every year. The sharp outperformance or underperformance could be due to what the market favours at the moment and how well those sectors and stocks are represented in the fund’s portfolio.
Adam Zoll, assistant site editor, Morningstar U.S., tells his readers that if a fund they owned surprised them this year—either positively or negatively--perhaps they need to get to know it a little better. What strategies worked, which didn't, and why? Reading up on the fund and digging into its portfolio to see how top holdings performed is a great way to look "under the hood" of how your fund operates.
There’s no need to get into a tizzy if your fund did lag the market this year. If it's a quality fund—this is where our analyst rating will help --don't jump ship just yet. Odds are the day will come when your fund is on the right side of the performance distribution chart.
To get a grip on the process the analyst follows when determining his rating, read How the Analyst Rating is arrived at.
To check the ratings assigned to various funds, click here.
