How we are upgrading our Fund Ratings process

By Russel Kinnel |  05-11-19 | 

We’re making some changes to our Morningstar Analyst Ratings methodology to make the ratings more systematic and to dial up the impact of expense ratios.

Russell Kinnel, Director – Manager Research, Morningstar, wrote about it in the October 2019 issue of Morningstar FundInvestor. Here's what you need to know. 

Beginning in October, we will start to rate funds under this new system, and you’ll see the first new ratings go live in November. Over the course of the next 12 months, we’ll rate funds using the new methodology, so you’ll see the changes roll in throughout the year.

There are three key changes on the way:

1. More weight on fees

We’ve always emphasized fees in our assessment, but we’re going to put even more weight on them in a couple of noticeable ways.

First, we’re going to assign Analyst Ratings to fund share classes, taking fee differences into account. Today, our analysts evaluate a single representative share class of a fund and assign it an Analyst Rating. Then, they apply that rating to every other share class of the fund, irrespective of fee differences. Going forward, the analysts will tailor the Analyst Rating to each individual share class, accounting for fee differences. This means costly share classes that bundle advice and sales fees could see ratings downgrades.

Second, we’re going to assess costs relative to how much value a fund can deliver before fees, not versus other funds. Today, when our analysts evaluate a fund’s fees, they do so by comparing its expense ratio with that of other funds in its peer group. Then, they assign it a rank and translate that rank into a Price Pillar rating, which they roll up with the other pillar ratings to arrive at the fund’s overall Analyst Rating. Going forward, they will compare a fund’s costs with the value they estimate it can deliver to investors before fees. This means 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.

2. Higher bar for active strategies

We’ve been selective when recommending active funds in the past, but we’ll be even pickier in the future, as we’ll be applying an even more exacting standard.

Today, for an active fund to earn a Gold, Silver, or Bronze rating, we might give the nod to active funds that can beat a relevant index or peer group average. Going forward, our research must convince us that the fund can clear a higher bar of beating both its benchmark and the average fund after fees and adjusting for risk.

We’ll also be taking a more structured approach to estimating how much value different types of active strategies can be expected to deliver before fees. Some types of investing have been more hospitable to active funds than others through the years. That track record should inform the expectations we set, which means that we’ll award more Gold, Silver, and Bronze ratings in some Morningstar Categories (that is, those that have been more target-rich for active funds) than others.

3. Pillars — People, Process, Parent

Our approach to evaluating funds has been comprehensive, but we’re going to refocus the framework so that it revolves around its more-predictive elements and is easier to understand and use.

To this point, we had organized our assessment around five pillars—People, Process, Parent, Performance, and Price. Going forward, we’ll assess People, Process, and Parent, which our research has found do the best job of predicting funds’ future performance before fees. In this way, we’ll be forming expectations of what a strategy can deliver to investors before fees in an even more systematic manner.

This means we’ll absorb the Performance Pillar into the other three pillars, ensuring that any performance analysis takes place as part of a broader assessment of the fund’s process, people, and parent. In addition, we’re re-expressing the Price Pillar assessment, for the reasons explained in the More Weight on Fees section. (To make it easier to tie a fund’s pillar ratings to its overall Analyst Rating and to facilitate more-refined comparisons between funds, we’re shifting to a five-point pillar-ratings scale of High, Above Average, Average, Below Average, and Low. This will replace the current three-point ratings scale of Positive, Neutral, and Negative.)

The revised Analyst Rating is designed to be a better road map for investors choosing between active and indexed strategies or deciding between different share classes. The updated assessment framework will consider how target-rich each type of strategy has been to active managers, and that will inform the ratings analysts assign. We’re likely to assign more Gold, Silver, and Bronze ratings to strategies in areas where active managers have enjoyed greater success, fewer in areas where they haven’t. In addition, because we’ll be taking fee differences into account when assigning Analyst Ratings to individual fund share classes, the ratings should be more useful to investors who are choosing between share classes.

Making Morningstar Ratings more effective

We’re refocusing around our framework’s more predictive elements, including our fee assessment, providing a clearer blueprint that should facilitate portfolio construction, and tailoring our ratings to individual fund share classes. Our research has found that the People, Process, and Parent Pillars do a better job of predicting a strategy’s performance before fees than other variables. We’ve also found that fees do the best job of all in predicting strategies’ future net-of-fee performance, explaining why we’ve put our fee analysis on the same footing as our assessment of people, process, and parent.

By identifying the areas more conducive to active investing, we can help investors choose between active and indexed strategies as they need to, facilitating portfolio construction. Finally, we’re tailoring our ratings to fund share classes by taking fee differences into account. This is designed to help ensure that the rating we assign to each share class precisely conveys our views on its future prospects, aiding investors in the process.

How it will work

We’ll follow a 6-step process in assigning Analyst Ratings. We follow this process to a large extent already, but the enhancements will further systematize the process by which we form expectations about a strategy’s potential and translate those expectations into an Analyst Rating.

1) Estimate potential alpha for the type of strategy being analyzed.

In this step, we will examine the historical record and estimate how much value strategies of that type have been able to generate before fees. The proxy for “value” is the dispersion of rolling 36-month pre-fee capital asset pricing model alpha (versus the benchmark index assigned to that category) of all funds of that type through the years.

This helps us form an estimate of the potential value we feel strategies of that type can add before deducting fees. We form one estimate for active strategies (based on their historical pre-fee performance) and another for traditional indexed strategies.

2) Assess how much of that potential the fund being analyzed can capture before fees.

In this step, we assess the fund by evaluating people, process, and parent. This assessment determines how much conviction we have in the fund to capture the potential we estimated in the first step. The more conviction we have—for instance, if we rate People, Process, and Parent as High across the board—the more of that potential we’ll assume that fund can capture, and vice versa when we have low conviction.

We assign weightings to each pillar we assess.

For active and strategic-beta strategies, we assign 45% weightings apiece to People and Process, 10% to Parent. By contrast, we assign an 80% weighting to Process when evaluating traditional indexed strategies and 10% apiece to People and Parent.

3) Translate our assessment into an estimate of how much value a fund can deliver before fees.

In this step, we translate our assessments from steps one and two into an estimate of how much value—measured as CAPM alpha—we feel a fund can deliver before fees. We do this by multiplying the strategy’s potential value (step one) by the weighting we give each pillar (step two) and multiplying that product by the pillar rating the analyst assigns (step two).

We’ve illustrated that process for active and strategic beta strategies in the schematic shown.

The process for traditional indexed strategies is identical to that shown for active strategies, but the weightings are different—10%, 80%, and 10% to People, Process, and Parent, respectively.

4) and 5) In the fourth and fifth steps, we deduct the fund’s fees from the estimate we formed in Step 3.

This will yield an estimate of how much alpha the fund can deliver to investors after fees.

6) In the final step, we translate that estimated net alpha into an Analyst Rating.

The process for translating estimated net alpha into an Analyst Rating differs depending on whether the fund is active (including strategic beta) or indexed. For an active fund to be eligible to receive a Gold, Silver, or Bronze rating, our assessment must convince us that the fund can deliver positive net alpha.

Of those fund share classes that we believe can deliver positive net alpha, we assign Gold ratings to the top 15% (that is, those whose estimated positive net alphas rank in the highest 15% of their Morningstar Category), Silver ratings to the next 35% of share classes, and Bronze ratings to the remaining 50%. Of those share classes that we do not believe can deliver positive net alpha, we assign Negative ratings to the worst 30% (that is, those whose estimated negative net alpha rank in the lowest 30% of their Morningstar Category) and Neutral ratings to the other 70% of share classes.

The process works the same way for traditional indexed funds, but with one notable difference: We do not insist that traditional indexed funds be able to deliver positive net alpha versus a relevant category index to qualify for a Gold, Silver, or Bronze rating. Rather, we assign Morningstar Medalist ratings to any traditional indexed fund whose net alpha we expect to exceed the median net alpha of fund share classes in that Morningstar Category or to be zero, whichever is lower. We consider any traditional indexed strategy whose expected net alpha exceeds that of the median fund, or is at zero, if lower, to have “positive alpha” in the image to the left.


Much of the ratings process is unchanged, as a result, the changes in Analyst Ratings won’t likely be dramatic. The biggest change that you will likely see is that higher cost Morningstar Medalists may get downgraded, especially in areas where the value-add of managers appears limited.

Add a Comment
Please login or register to post a comment.
Mutual Fund Tools
Ask Morningstar