Have you ever eaten at a restaurant that was very highly rated by a reliable food critic, but came away disappointed? And on asking around, you were told that the restaurant’s long-time chef had recently quit. The high rating, therefore, reflected how good the food used to be, not how good it is now.
That the future doesn't reflect the past isn't news to most investors, yet many rely heavily on backward-looking ratings (like the Morningstar Rating) to make decisions. Commonly referred to as the star rating, it plots funds' risk-adjusted returns over three, five and 10 years against their relevant peer groups along a bell curve. The funds with the best historical risk-adjusted returns earn 4- and 5-star ratings.
Since it is a pure quantitative, backward-looking measure, which relies only on performance, it won't tell you whether a manager or strategy has changed. Even if that's not the case, the rating can be strongly influenced by market conditions. A fund may garner a 5-star rating because it’s portfolios is chockfull with the flavor of the season – be it commodity stocks, infotech stocks, infrastructure stocks, or mid-cap stocks, as was the case not too long ago; not because the manager was especially skilled.
Also, over shorter periods, funds can be successful simply because of random chance. (The star rating measures up to 10 years of returns, but performance over the 3- and 5-year periods can strongly influence the rating.) These funds may be at the top of the heap for a brief spell, but that's unlikely to remain the case over the long haul.
Even in instances where the numbers appear to tell a cut-and-dried story, the truth may be more complicated. A fund may have excellent long-term returns, but if the fund has become too big to invest in the small-cap names behind its winning record, it may have a tough time replicating its past. Or it may be the case that performance appears mediocre, but that's only because the strategy has been out of favour. In this case, the future may be better than the recent past.
Enter the Analyst Rating..
As opposed to the backward-looking star rating, there are qualitative ratings which investors can consider. Morningstar’s analyst rating is the summary expression of the forward-looking analysis of a fund. It is based on the analyst's conviction in the fund's ability to outperform its peer group and/or relevant benchmark on a risk-adjusted basis over the long term.
The analyst rating is based on analysts' comprehensive assessment of the people, process, performance, parent and price supporting a fund -- the five pillars of Morningstar's approach to research. We consider whether a fund has a competitive advantage in each of the five areas.
Instead of stars, analysts award medals -- Gold, Silver or Bronze -- based on the strength of these advantages. The more precious the metal, the more confident we are in the fund's ability to deliver above-average risk-adjusted returns versus peers and/or benchmark over a full market cycle of at least 5 years. The rating has been developed to identify not only good funds, but also mediocre and poor investments through Neutral and Negative ratings. These will be funds with no clear competitive advantages or glaring disadvantages, while funds likely to underperform get Negative ratings.
How to use the Star Rating
The star rating is a great starting point and helps investors get a sense of each fund’s risk adjusted return. But you should not base your decision on a fund solely because of its current star rating. You need to combine it with some fund analysis. The analyst rating will help you here.
Morningstar developed the analyst rating because the star rating tells only part of the story. We think of the star rating as an achievement test and the analyst rating as more of an aptitude test. The two can be used in conjunction, together with the fund reports, to provide investors with a powerful tool to assess funds.
Because the analyst rating is forward-looking, it won't always match the backward-looking star rating. Don’t expect a Gold fund to necessarily have a 5-star rating and a Negative fund to have a 1-star rating.
It could be the case where our analyst awards an analyst rating of Gold to a fund with two stars, if the analyst believes the fund could outperform its peers, despite underperforming over the trailing three-five-and 10-year periods. In contrast, if a fund outperformed its peers over these periods, but our analysts don’t think it will be able to sustain that performance, a 5-star fund could receive a Negative rating.
