Winners And Losers Among The First Batch Of Morningstar Analyst Ratings

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Includes: APGAX, IWB, IWN, LMGTX, MPEGX, OAKMX, POAGX, SEQUX, VHCOX, VPMCX
by: InvestETF

Summary

Morningstar has two fund rating systems, the quantitative, inherently backward-looking star rating and the qualitative, forward-looking analyst rating.

We examine the performance of gold-rated equity funds and found that they beat the category average over the subsequent five years.

While they beat their category peers, on average, they trailed a low cost index fund.

Morningstar has two fund rating systems, the star rating and the analyst rating. The star rating is a quantitative, backward-looking ranking of a fund's risk-adjusted performance within category over the past 3, 5 or 10 years. Star ratings are fit to a bell-shaped curve with 10% of funds receiving a five-star rating, 22.5% receiving four stars, 35% receiving three stars, 22.5% receiving two stars and the remaining 10% earning one star. The star rating can be applied to essentially all funds with at least a three-year track record (except for a handful of categories that don't receive a rating or if there are too few funds in a category to rate). Star ratings are updated monthly and they are calculated mechanically without any editorial input. This is different than the star rating for stocks, where a five-star rating on a stock is essentially a buy recommendation while a one-star rating is a sell recommendation for a stock.

Although Morningstar does not recommend using the star rating as the sole factor in an investment decision, it does say that the star rating "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." Morningstar finds that the star rating does have some moderate predictive power. Investors often look to the star rating, and fund companies are all too eager to advertise when their funds receive four or five stars. According to Morningstar, five and four star funds have a disproportionate share of assets and flows. In 2016, five and four star funds garnered $303 billion in inflows compared to $98 billion in outflows from two- and one-star funds. By assets, five- and four-star funds had 63% of assets while by count of funds, five- and four-star funds make up just 32.5%. For comparison, two- and one-star funds had just 8% of assets.

In contrast to the star rating, the analyst rating is more qualitative and is intended as a forward-looking assessment of a fund's future prospects. Only funds that Morningstar analysts cover receive the analyst rating. Funds are rated based on five pillars: price, performance, process, people, and parent. Each of these pillars is given a positive, neutral or negative rating, and these component scores are totaled into the analyst rating which has five tiers: gold, silver, bronze, neutral, and negative.

"Morningstar reserves the top three tiers, expressed as medals, for funds its analyst team thinks have sustainable advantages that position them well versus peers and/or a relevant benchmark on a risk-adjusted basis over a full market cycle of at least five years."

Of the five pillars, the assessment of price and performance is probably quantitative while process, people and parent is likely more qualitative. Morningstar's advantage comes in the assessment of three pillars. Morningstar is likely to have greater access to fund management personnel than an individual investor ever would.

Morningstar launched the analyst rating in November of 2011, just over five years ago, so looking at this first batch of funds' current five-year star rating should be a good way to assess how their picks have performed. I took a look at gold and negative rated equity funds only. I excluded funds in other categories and silver, bronze and neutral rated funds because I did the calculations by hand and wanted to keep the size of the list manageable. There were 54 gold-rated equity funds and four negative-rated funds. Of the 54 gold-rated funds, 51 survived unchanged. Two of the funds were merged (Vanguard Tax-Managed Growth & Income and Morgan Stanley Focus Growth) and one was liquidated (Morgan Stanley Mid Cap Growth). Given the high attrition rate of mutual funds, three fund changes out of 54 funds is not bad.

Several gold-rated funds have had stellar performance. Oakmark (MUTF:OAKMX) returned 13.88% compared to 13.12% for the benchmark. Vanguard PrimeCap (MUTF:VPMCX) returned 16.31% versus 13.11% for the benchmark. Vanguard Capital Opportunity (MUTF:VHCOX) returned 17.27% compared to 13.11% for the benchmark. PrimeCap Odyssey Aggressive Growth (MUTF:POAGX) returned 19.38% versus 11.74% for the benchmark. There were also some spectacular failures. Sequoia (MUTF:SEQUX) returned 6.59%, trailing the benchmark by 6.53%. The fund is now rated bronze. Morgan Stanley Institutional Mid Cap Growth (MUTF:MPEGX) returned a measly 3.66% compared to 11.74% for the benchmark. The fund is now rated silver.

The average five-year star rating of the 51 surviving gold rated funds was 3.5. This should be viewed as a success since gold-rated funds performed better than the category average, which should be around three stars. These funds beat the category average return by 83 basis points on average and 36 out of 51 funds beat the category average. The performance was less impressive when compared against a low cost index fund. I compared each gold-rated fund against a corresponding iShares Russell index fund. For example, funds in the large blend category were compared against the iShares Russell 1000 (NYSEARCA:IWB) while funds in the small value category were compared against the iShares Russell 2000 Value (NYSEARCA:IWN) etc. Measured this way, gold-rated funds lagged their corresponding index by 62 basis points.

Of the four negative rated funds, two still exist (AllianceBernstein Large Cap Growth (MUTF:APGAX) and Legg Mason Capital Management Growth (MUTF:LMGTX)) and two were merged away (American Century Vista and Winslow Green Growth). The two negative rated funds that still exist have had good performance. Earning five and four stars, respectively. Although Legg Mason Capital Management Growth is now called ClearBridge International Growth and is categorized in the foreign large growth category rather than large growth, where it started. This fund is no longer rated while APGAX is rated neutral.

In Conclusion

Morningstar has two rating systems for funds. The star rating is a backward-looking risk-adjusted performance scorecard. The analyst rating is a forward-looking opinion. The analyst rating was launched in November of 2011, and while the first batch of gold-rated equity funds beat the category average, they trailed a low cost index fund.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.