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Advisor-Sold Funds Could Be Downgraded Under Morningstar’s New Rating System

Going forward, Morningstar will provide Analyst Ratings for each share class of a fund, which could mean downgrades for those with high distribution fees.

Morningstar is changing the underlying engine for its Analyst Ratings, including a shift from fund level ratings to share class level ratings. The research shop expects to see more downgrades as a result, and it could primarily affect funds with fees aimed at compensating advisors.

“We think that costlier share classes that bundle distribution, advice, service fees of various kinds are likely to see downgrades as a result,” said Jeffrey Ptak, Morningstar's head of global manager research.

Ptak said the change could hurt advisor-sold funds, but it doesn’t necessarily mean they'll see a downgrade. It depends on what the fee increment is and what analysts believe the strategy can deliver to investors before fees come into play.

“This new iteration of their rating systems, I think, is long overdue,” said Kashif A. Ahmed, founder and president of American Private Wealth in Bedford, Mass. “Most advisors—and I’m certain pretty much every retail investor—have no clue what kind of letter comes after the name of the fund. Most of them will never know the difference between I and T and R and N.”

"Morningstar wants to shine a light on overall investor costs in the otherwise opaque share class maze." said Jamie Cox III, managing partner at Harris Financial Group in Richmond, Va.

When you look at the unique U.S.-based funds that are rated by Morningstar, about 62% are medalists (Gold, Silver and Bronze), while the remaining 38% are rated Neutral or Negative. Ptak expects that to flatten out, with some of the funds rated Bronze getting kicked down to Neutral when the changes go into effect Oct. 31.

Morningstar’s Analyst Rating is its forward-looking rating, based on analysts’ qualitative assessment of a fund’s investment merits. The ratings spectrum, which includes Gold, Silver, Bronze, Neutral and Negative, is not changing. (The changes do not apply to the firm’s star ratings.) What is changing is the way the researcher arrives at its Analyst Ratings conclusion. The reasoning behind the changes is to make the ratings more effective for investors, increasing the focus on fees.

Ahmed expects some funds may get thrown out of model portfolios at wirehouse firms as a result of the changes, but “I suspect the average run of the mill advisor’s probably not even going to notice.”

He doesn’t expect many changes to the ratings of the funds he uses with clients; he invests in institutional share classes, which tend to have the lowest expense ratios.

In addition to the share class change, the firm is also raising the bar for active funds to receive medals. To this point, Morningstar awards Gold, Silver and Bronze to funds that are capable of beating either a relevant benchmark index or a peer group average; in the future, an active fund will need to clear both of those hurdles.

“Active strategies which can’t beat a relevant benchmark index after fees and adjusting for risk will cease to be eligible for gold, silver or bronze rating from our analysts,” Ptak said.

For index funds to be eligible for Gold, Silver or Bronze, they must have a high likelihood of generating a higher net alpha than the median fund share class in their peer group or zero, whichever is lower.

Morningstar considers strategic beta funds, however, to be different than traditional index strategies, as these aim to outperform an index. They’ll be subjected to the same two hurdles as active strategies.

In addition, the firm will look at fewer “pillars” when assessing a fund. Currently, it assesses funds based on five criteria: people, parent, process, performance and price, which serve as organizing principles for its research. Going forward, it will focus on people, process and parent, to make the framework easier to understand.

“It also refocuses us on the three pillars that we think do the best job of helping us to estimate, form expectations of what it is a strategy can deliver to investors before fees come into account,” Ptak added.

Those pillars will now be assessed on a five-point scale (high, above average, average, below average and low) versus the previous three-point scale.

The firm will make accompanying changes to its Quantitative Rating, which uses machine learning to assign ratings to funds not covered by an analyst, but Morningstar doesn’t expect a significant number of upgrades or downgrades of those funds.

Morningstar also announced changes to its Sustainability Rating, introduced in 2016 to provide insight into each fund’s environmental, social and governance impact. Previously, the ratings were more concerned with the general evaluation of how well a company was addressing ESG issues, said Jon Hale, global head of sustainability research. Now, the ratings will be more focused on material ESG risk, the risks that could materially impact the financials of a company if not managed appropriately.

“The main difference will be that funds that decide to overweight or underweight particular areas of the market that may have particularly high ESG risk or particularly low ESG risk could affect the rating of that fund in a way that cannot happen today,” Hale said.

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