Morningstar CEF Ratings: Good Inverse Share Price Performance Predictor

by: Joe Eqcome

Conclusion: Morningstar CEF ratings system (“The Morningstar Rating™ for Funds” or “star rating”) continues to be a good inverse predictor of CEF share price performance over a short period of time (12 to 18 months). Investors should not use the CEF “star rating” system (“1”: least favorable; “5”: most favorable) as a guide for picking stocks in the CEF universe as that is not its purpose.

In fact, investors would be better off picking the lowest Morningstar CEF “star rating” (Rating “1”) as it has consistently generated better share price performance than the higher ratings (“2” through “5”) for a 14 to 16 month period.

Summary: In a previous article entitled Morningstar CEF Rating System: Worse than Random (6/05/10) it was demonstrated that for a 14 month period, from March ’08 to May ’09, the “star rating” system proved worse than random as a CEF stock picking tool. With the exception of their lowest rating (“M*1 Rating”), the Morningstar rating system for CEFs was a perfect contrarian indicator.

Morningstar CEF Ratings Revisited: To determine whether the previous results were a function of that particular period in time, the Morningstar CEF rating System was retested for over 500 CEFs in the adjacent period of time to determine the relationship between ratings and share price performance. Not only was the initial conclusion of the original article confirmed, the inverse relationship between ratings and performance was inversely perfect.

Retested Period: That period spanned from June ’09 to October ’10—a comparable period of 16 months. Morningstar CEF “star ratings” were employed as of June 1, 2009.

As the chart below illustrates, there continues to be an inverse correlation between the Morningstar ratings and average price change for CEFs so rated on its “1” to “5” star rating system.

Morningstar Rating Systems: Unlike “The Morningstar Rating™” system for corporate stocks (based on the Morningstar’s fair value assessment versus the stock price), the CEF system is not designed to be predictive with regards to stock price performance.

The definition of its CEF rating system is “a quantitative assessment of a fund’s past performance.” Additionally, and I quote: “is intended for use as the first step in the fund evaluation process. A high rating alone is not a sufficient basis for investment decisions.”

Star Crossed: So, unlike the predictive nature The Morningstar Rating™ system for corporations, e.g. IBM, the CEF star rating system (The Morningstar Rating™ for Funds) is presented only as a staring point for further analysis. Consequently, to the untrained eye, the “star” ratings appear the same for each with no distinction on Morningstar’s website. This could easily be confused by retail investors as a “buy”, “hold” or “sell” rating system.

This confusion could easily be remedied by Morningstar having a hyperlink to the funds and non-funds (corporation) respective rating definitions. However, this is too easy a solution.

Bass Aackwards: So, for CEF investors, if the star rating system is suppose to be a starting point, then I suggest investor start with the lower ratings—in particular the “1” star rating—rather than the higher ratings—if your goal is to achieve better share price performance over a 12 to 18 month period. (For Morningstar CEF ratings, click here.)

Why Does This Inverse relationship Occur? While there are a lot of reasons for CEF price movements, one of the causes may be relative historical valuations. Since Morningstar’s CEF ratings are materially based on historical performance, there is a tendency of poorer performing CEFs to exhibit larger price to NAV discounts that attract value investors looking for mispriced securities. This is one possible explanation; there may be others that are more important.

Disclosure: Author owns a diversfied portfolio of CEFs and ETFs as well as CEFBig10, CEFMuni10 and CEFDisc10 Eqcome Portfolios