Investors looking for the best mutual funds for their portfolios have typically had little direction in making those decisions. While the Morningstar star rating system has often ended up standing in as a recommendation service, it wasn't really designed to serve that purpose. Because the star system looks at past performance and risk-adjusted returns, star ratings are usually a better rear view mirror look at a fund, rather than a forward-looking dashboard view.
Now, though, things are changing. A new rating system on the horizon could have meaningful implications for the mutual fund world.
The next level
At their recent annual Investor Conference, Morningstar announced that it plans on adding new, more subjective analyst ratings to the wide universe of mutual funds. In contrast to the star ratings, the analyst ratings will be an attempt to judge how funds will perform in the future. Funds will receive a positive, neutral, or negative rating based on analyst expectations. Positive analyst ratings will be designated by AAA, AA, or A ratings, based on how relatively advantageous each fund is perceived to be. Morningstar expects roughly 10%-20% of all funds to earn some type of positive rating. Ultimately, the new analyst ratings are designed to be broader in scope and more responsive to potential changes at each fund.
While there's a lot of potential for things to go wrong in a rating system like this, an initial glance at the criteria Morningstar analysts will be using to rate the funds sets my mind at ease. There are five key areas that Morningstar believes predicts future performance. These include cost, investment process, past performance versus expectations, management skill, and company culture. These are all aspects of funds that investors should focus on anyways, so I'm glad to see these criteria being incorporated into a forward-looking measure.
While investors typically look to past performance as a primary screen when picking funds, I have long argued that performance is actually one of the last criteria that should be considered. It's more important to first find low-cost funds with long-tenured managers or management teams.
The next step is to home in on those funds with a consistent investment process and a long history of managing money in the same manner, rather than those that shift focus as the investing winds change direction. Only once you weed out the funds that don't meet all these criteria should you consider performance. Here, you want a fund that has a track record of solid performance in both good and bad market environments, not a one-trick pony. Since it looks like most of these measures will be incorporated into the analyst ratings in some way, I think Morningstar is on the right track here.
Due diligence still required
But while the new analyst ratings will likely go a long way toward helping folks narrow down the available universe of funds and hopefully make some good picks, investors shouldn't use these new ratings as an excuse to mentally check out of the fund selection process. These analyst ratings are absolutely no guarantee of future performance, and fund investors are still responsible for understanding how their chosen funds invest and what they own. In other words, don't think you can get away with just picking all AAA-rated funds and not give your portfolio a second thought.
I also think there is some potential for investors to buy inappropriate funds based on these new ratings. The analyst ratings may tell you which funds Morningstar thinks will do better than others, but that doesn't mean the fund is right for you. While a China-focused fund or a cloud computing tech fund may earn high marks, that doesn't mean that the average investor should own such an investment. There are lots of funds out there that post attractive returns and may be very well-run, but still aren't the best option for any particular individual.
And while the new rating system should help weed out some less attractive funds, it won't give investors any additional insight into the asset allocation process. In other words, how do those positive-rated funds fit into your overall portfolio? Investors will still need to start with an appropriate, well-planned asset allocation before even thinking about which funds they should be buying. If they don't get that step right, all the analyst ratings in the world probably won't be able to rescue their portfolio.
Ultimately, I think these new analyst ratings should be a good thing for fund investors -- if they are kept in context. More specifically, as long as investors don't come to rely on the ratings as their sole analytical tool, I think they could be a valuable part of one's fund selection process. Keep an eye out as Morningstar unveils these ratings beginning this fall. They could mark an important turning point for the mutual fund industry.
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