Morningstar Inc. has announced a change to the methodology for its Morningstar Medalist Rating system that it says provides a more precise assessment of investment alpha. The change, which will take effect on Oct. 29, will alter the medalist ratings of about 20% of the 200,000 funds Morningstar has rated, with most of those changes downgrades. For example, Morningstar expects around 40% of funds currently assigned Bronze ratings globally will be assigned Neutral ratings after the change.
The change refines Morningstar’s framework for forecasting future returns but maintains the same process for assigning ratings. Using historical data, Morningstar said the updated framework introduces a more precise assessment of how much value a managed investment can add before fees compared to its assigned benchmark. Morningstar calls this piece the Alpha Potential Estimate.
According to an article from Morningstar Chief Ratings Officer Jeff Ptak explaining the change, he pointed to the current methodology leading to overestimates of “how much potential value a fund can be expected to generate before fees.”
“Our animating principle is ‘investors first.’ We want our rating system to help investors make better investing decisions," Ptak said in an interview with WealthManagement.com. "It’s a forward-looking system. When investors are testing its mettle, they are going to ask how good of a job it does in assessing future outcomes. That’s what we aspire to do. We want to make sure that it sorts well on future performance.”
Morningstar is replacing that methodology with an “approach that better accounts for the likelihood and magnitude of delivering positive value before fees,” Ptak wrote.
“While dispersion boasts simplicity and can convey useful information about the range of outcomes before fees, it can face drawbacks when the distribution of alphas skews negative,” Ptak wrote. “Specifically, in instances where there’s a wide dispersion of before-fee alphas but the median alpha is less than zero, a dispersion-based measure can lead one to overestimate how much potential value a fund can be expected to generate before fees.”
The Morningstar Medalist Rating is a five-tier system designed to evaluate an investment strategy’s potential to outperform a relevant index or peer group over the long term. Ratings are assigned on a scale from Gold to Negative based on evaluating how much value a managed investment can add compared to its assigned benchmark after fees and three pillars—people, process and parent—that determine Morningstar’s conviction in a particular investment strategy.
Morningstar broke down the changes: 15% of the 200,000 funds will receive downgrades, while 3% will receive upgrades. Among Gold-rated funds, 33% will be downgraded to Silver. Among Silver funds, 2% will be upgraded to Gold, and 38% will be downgraded to Bronze. Among Bronze funds, 2% will be upgraded to Silver, and 41% will be downgraded to Neutral.
“Our medalist rating denotes our conviction in a managed investment to deliver value after fees adjusted for risk,” Ptak said. “With this particular enhancement, we are seeking to make it better for investors to identify worthy funds. After fees adjusted for risk is an important part.”
Morningstar’s methodology compares how much value a fund can deliver before fees, adjusted for risk, factor in the fees and the difference between those two yields gives a sense of how much value a fund or an ETF can deliver.
“When it came to this enhancement, we were focused on the first piece: How much value can a fund deliver before fees, adjusted for risk,” Ptak said. “When you focus on that element, it’s a factor of two variables. The first variable is how much potential there is for a fund of a given type to add value before fees adjusted for risk and how much conviction we have in a particular managed investment of that type to capture that potential. Those are the things that serve as the organizing principle.”
Despite the number of funds that will be affected, Mario Favetta, a relationship manager with FUSE Research Network, said the overall market impact may be muted. (FUSE provides tactical decision support for investment management firms.)
“I don’t know that it’s going to be that big of a deal. It is likely to result in a lot of changes in the medalist rankings, but it’s unclear how that’s going to impact actual flows into and out of funds,” Favetta said. “From the clients we talk to, the medalist rankings are interesting, and they are an input in due diligence, but most independent broker/dealers and RIAs are doing their own due diligence. It’s an input, but I don’t know if it’s the most important input.”
After the methodology change, Gold, Silver, and Bronze ratings are projected to account for around 23% of rated global funds, compared with about 30% today. In his article, Ptak wrote that Morningstar expected allocation and equity funds to see more rating changes than fixed-income funds.
Morningstar assigns ratings in two ways: by analyst or by algorithm. According to Ptak’s article, Morningstar analysts assign ratings to funds they cover based on qualitative evaluations they conduct. The rest of the ratings are assigned via a machine-learning algorithm. Morningstar expects more changes to analyst-assigned ratings.
“The higher rate of change among analyst-assigned Medalist Ratings is largely explained by the distribution of ratings,” Ptak wrote. “Namely, Gold-, Silver-, and Bronze-rated funds constitute a larger share of Medalist Ratings assigned by analysts than they do Medalist Ratings assigned by algorithm, and we expect these higher-rated funds to see more changes than lower-rated funds.”
Morningstar is also refining the algorithm that evaluates the “process” pillar of passively managed equity vehicles that are not covered by an analyst. The updated approach will employ a rules-based system that more closely aligns with how Morningstar’s Manager Research analysts evaluate the process pillar of the ratings for these types of investments.
