Morningstar fund ratings evolve beyond the stars

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BOSTON (AP) ? A 5-star rating might not be enough to instill confidence in mutual fund investors. That’s unless a fund is also able to dazzle with “gold” credentials under a ratings system that Morningstar is launching.

The “Analyst Ratings” debuting on Tuesday will supplement Morningstar’s well- known performance-based star ratings system. The new ratings will run from gold, silver and bronze, down to neutral and negative. The aim is to give investors a snapshot of a fund’s prospects, rather than its record, based on the judgment of Morningstar analysts.

That subjective approach will inevitably lead to occasional bad calls. Some positively rated funds might ultimately underperform their peers, while a few could rise above their low expectations.

But Morningstar hopes the new ratings will prove more useful in predicting future performance than its 1- to 5-star system. Both are designed to help investors and their financial advisers narrow the list of potentially worthy funds among the more than 7,000 to choose from.

Funds are awarded stars based on past returns, and the degree of investment risk taken to achieve those results. Morningstar has long acknowledged those measures aren’t necessarily helpful in predicting fund performance, and many industry professionals dislike the star system.

“It’s like using a rear-view mirror to drive,” says Geoff Bobroff of Bobroff Consulting.

Because of that weakness, Bobroff and others say the industry’s new seal of approval for assessing a fund could become gold credentials as well as five stars. One or the other may not be enough.

And a fund company may be reluctant to tout a 4- or 5-star fund on its website or in advertisements unless it also has a halo of gold.

“‘Rated bronze by Morningstar’ just doesn’t have much of a ring,” says Adrian Day, of Adrian Day Asset Management, a manager of $160 million for individual investors.

Morningstar isn’t the only company ranking funds ? others include Lipper, Standard & Poor’s, Zack’s Investment Research, and U.S. News & World Report.

But Morningstar’s are the most influential. Research firm Corporate Insight found that more than three-quarters of fund companies display Morningstar ratings for their funds on their websites.

Here’s more of what you can expect from Morningstar’s new analyst ratings:

? When they’ll start to appear: Morningstar will begin the gradual roll-out by publishing analyst ratings on about 300 funds, focusing on the biggest in terms of assets. Also expect to see smaller funds that are noteworthy because of their distinguished records. By the end of next year, Morningstar plans to have issued analyst ratings on about 1,500 funds, representing more than 75 percent of industry assets.

? How to find ratings: Visit Morningstar’s website and plug in a fund ticker or name. Gold, silver, and bronze icons will signify funds with positive ratings, while lesser-rated funds will be labeled neutral or negative. The ratings will appear at the top right of a fund’s page, just above the star rating.

? How the ratings fit in: Star ratings won’t go away, but the analyst ratings will replace Morningstar’s “Analyst Picks” and “Pans.” Those are funds that Morningstar analysts consider top choices within their investment categories, or ones to avoid. Less than 3 percent of funds are designated as picks. Morningstar expects all those funds will get positive ratings under the new system.

There’s no target for how many funds will earn gold. “We’re not managing to a bell curve, where we’re going to force 15 percent into negative ratings, or 5 percent into gold,” says Karen Dolan, Morningstar’s director of fund analysis. “Each fund will be assessed on its merits.”

Many 5-star funds could get neutral ratings if analysts see weaknesses ? a top fund manager who’s about to retire, a dicey reputation at the fund company ? despite strong past performance. If those shortcomings are deemed minor, the fund might still finish in the medals, with silver or bronze.

With the debut of analyst ratings, many gold-rated funds could rapidly attract new cash. Morningstar acknowledges there’s risk in such instances. When cash surges in, the fund’s manager might have a hard time effectively putting it to work in the market, possibly leading to disappointing performance.

But fund research director Russel Kinnel says Morningstar analysts will try to warn investors of such risks. And he expects there will be many instances where a neutral or negative analyst rating alerts investors to avoid a fund that’s poised to suffer a period of underperformance, despite having a 5-star record.

Based on recent results, Morningstar appears to be able to spot the winners more often than not. U.S. stock funds that Morningstar designated Analyst Picks have returned an average 4.18 percent per year over the past five-year period on an annualized basis, the company says. That’s better than the 3.32 percent return for the Standard & Poor’s 500 index. The advantage is a bit bigger for international stock funds, where Morningstar’s analyst picks have returned an average 4.23 percent versus 1.7 percent for a broad international stock index.

But Bobroff, the industry consultant, says the new analyst ratings may not become widely influential until they have a track record of a few years, and Morningstar can demonstrate that they’re useful. Predicting which funds will fare best is an unusually difficult task now. “To make effective predictions in these very choppy markets,” he says, “may well be an uphill challenge.”

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Questions? E-mail investorinsight(at)ap.org