Picking Funds the Morningstar Way

Jun 07, 2013
Elaborating upon the five Ps that we believe our critical to a fund’s potential and central to our Analyst Ratings.

While Morningstar started off as a mutual fund research specialist in the U.S. in the mid ‘80s and then gradually broke into other related fields such as equities and ETFs, funds were at the heart of what we did.

We created the world’s foremost (and arguably the most popular to this day) mutual fund rating system, commonly known as the star rating, a one-to-five scale system, where a high rating signified the fund has performed better than peers on a risk-adjusted return basis, historically.

Over the years, we also wrote realms of analyses on mutual funds and provided our view to fund investors across the world over which funds, we believed, stood out in the industry and which didn’t.

In 2010, in conjunction to our decades-old backward-looking, quantitative (which means we have no control over individual rating awarded to each fund) Morningstar Rating, we distilled the learning of our years of experience in the field of fund research to launch a parallel system: a forward-looking, qualitatively-driven Morningstar Analyst Rating, which we decided would be our bold call on individual mutual funds across the world.

Here’s a quick overview of what our Analyst Ratings stand for: we rate funds on what we believe are the five most crucial factors that are vital to a fund’s chances of doing well in the future. These are what we call the five Ps: people, parent, process, performance and price (we’ll discuss each in a bit more detail later in the piece).

Each Analyst Rating is arrived at after our analysts’ evaluation of the five important factors that we think make or mar a fund’s potential, and the evaluation culminates in the form of a five-scale rating of either Negative (fund is likely to underperform peers), Neutral (we think future performance will be in line with category average) or Bronze, Silver and Gold (we have conviction in varying degrees the fund will outperform peers).

What are the Analyst Ratings not? They are not a short-term call but our view on a fund’s potential over a full market cycle of five to seven years. So we won’t be surprised or worried if a highly-rated fund underperforms the market or peers for a year or even two, as long as we believe the five fundamental factors are still in place.

They are also not a market call: a Gold-rated large-cap fund does not mean large-cap stocks are likely to do well or a Silver rating on a long-duration government-bond fund says G-secs are the way to go. Simply put, we aim to identify how well each fund in a category is likely to do, compared to its peers, not independently.

With that out of the way, let’s talk about the five pillars that we believe are crucial to a fund’s potential and central to our Analyst Ratings for mutual funds.


Here we look at the investment team that manages the fund in question, its overall experience and performance in the industry, as well as the support staff that runs the fund.

What, in effect, we are looking for is whether the fund manager(s) is at home with his investment style and it suits the area in which he is working.

We will have no special preference for a manager’s style: whether he follows a top-down or a bottoms-up approach or whether he is a value or growth investor.  For every Prashant Jain who follows a low-turnover, value-conscious, Buffett-esque approach, we have a Sankaran Naren who follows a more active approach. We will view each approach favourably if we believe it can yield results.


Here we look for fund houses that we believe put investor interest first, how their offerings overall have done in the past, how are managers remunerated and whether the fund company has been able to retain talent, among others.

So key factors we evaluate are: whether the AMC has had a history of having an undue focus on asset gathering (a key indicator would be its behavior during the pre-2008 bull run when many firms launched multiple, almost-identical funds), and whether its fund line-up differentiates itself by way of each fund having a unique proposition to offer.

Other notable areas we look at: how successful the firm’s equity or debt practice has been, whether managers are rewarded on the basis of their short- or long-term performances, if the investment team has been stable over the years and the workload on the investment team, in proportion to the number of funds it manages.


As mentioned earlier, our analysts are fairly agnostic to a fund manager’s investment style--we only see if we think it will work within the framework it operates.

We also see if the Process is followed at an institutional level or at an individual level: we will warn investors of key-man risk if the process is unique to the fund manager at the helm.

Similarly, we will also elaborate on what you could expect from the process the manager follows: we would advise risk-conscious investors to be mindful of a fund’s volatility if we believe it follows a rather aggressive approach or point out a highly value-conscious fund could underperform markets in the midst of a roaring bull run.


For long, the investment industry’s critics have complained it pays too much attention to past performance, which may or may not be indicative of future results. Thus, for us, past performance is only one of the factors that go into our view of a fund.

We look at a fund’s historical risk-adjusted performance, factors that drove it and see whether those factors are likely to persist in the future.

For instance, if a fund has had a robust long-term performance but under a key manager who has now left, or if the fund recently underwent a radical makeover in its Process, effectively meaning there is no cue to be gained from the past, we may ignore the Performance factor altogether.


In price, we look at the expense that investors bear as asset management fee. Too many studies in the West have proven that costs that investors pay (as they ultimately eat into returns) are often the only deciding factor whether they will earn a return more than the market.

However, in emerging markets like India, where chances of alpha are higher and skilled fund managers are known to convincingly beat their benchmarks, Price is not something that is considered as generally vital while selecting a fund but we still suggest not overpaying for performance.

Of course, even in our markets, Price becomes an important factor in potential success for bond funds where returns may not be that high.

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Kamalakant Roy
Jul 21 2013 11:52 PM
excellent approach....
prakash thosar
Jun 19 2013 03:58 PM
nice, indeed!!!!!!very informative !!!!!!!!!!!
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