Three key findings from Morningstar's new ratings

Earlier this week, I wrote about Morningstar's new forward looking rating system. The goal of these new ratings is to better predict future performance within each fund's category. Morningstar first rated 349 funds, giving them ratings of gold, silver, bronze, neutral, or negative. I examined the data and the methodology and here are some key findings:

Gold is common

Though gold is a rare element in the real world, it is the most common element in Morningstar's new ratings. More than 44 percent of the initial funds rated received a gold rating, while over 31 percent ranked silver. In fact, only about 24 percent received bronze or lower, including about two percent garnering a negative rating.

I calculated an average grade as if each fund was a student in my class. I gave gold 4 points, silver 3, bronze 2, neutral 1, and negative 0. Thus, gold would be an "A," silver a "B," bronze a "C," neutral a "D," and negative an "F." The grade point average of the 349 funds rated was a 3.07, or a high B, which isn't so different from the average in my classes. This means, however, that a silver rating is a bit below average.

Morningstar managing director, Don Phillips, stated that this was because the initial funds selected were heavily weighted towards another Morningstar system known as "analysts picks. " Phillips says Morningstar hopes to rate 1,000 additional funds over the next year and expects a lower average rating for future funds to be included.

Vanguard rated highest of three largest families.

Morningstar rated 68 Vanguard funds, 37 Fidelity fund, and 23 American funds. Vanguard's average grade was a 3.49, while American scored a 3.17, and Fidelity garnered a 2.89, significantly below the 3.07 average of all 349 funds.

None of the top three families had a negative fund, but Fidelity's average was brought down with nearly 30 percent receiving bronze and neutral ratings. The Fidelity Magellan is one of those receiving a neutral rating.

It's not a level playing field

A gold rating may not imply that Morningstar believes it will outperform a fund in the same category receiving a silver rating. That's because the price (cost) rating is given relative to the distribution channel. The translation is that loaded funds are rated against other loaded funds and not against the total universe of funds in that category.

Because American funds are distributed exclusively by advisors while Vanguard pays no distribution commissions, American funds were graded on an easier curve than Vanguard. Fidelity uses a combination of directly and advisor-sold distribution channels.

My view

I'll be following Morningstar's new ratings with interest, and look forward to more research on how they work going forward. While I wish Morningstar didn't differentiate the price ratings between loaded and non-loaded funds, the fix is simple. Always avoid loaded funds.

I'm a believer that one can build an ultra-diversified and low cost portfolio with three funds that I call the core second grader funds:

Vanguard Total US Stock (VTSAX)

Vanguard Total International Stock (VTIAX)

Vanguard Total Bond (VBTLX)

All three garnered gold in Morningstar's ratings. Thus, I think it's fair to say that Morningstar's thinking and mine have far more similarities than differences.

[TheFinanceBuff]

Where do I see a list of these rated funds other than looking at the fund profile one at a time? I see the Vanguard 500 fund got a Silver. Which six Vanguard funds got Bronze and Neutral?

[Allan_Roth]

I don't know of a public site that lists all of the funds & the list was shared with me only for the purposes of my piece. Sorry about that.

[WallStreetRanter]

You correctly point out how few negative ratings there are but you didn't mention how rediculous it is that those INDEX funds you mentioned got a gold rating! While it is true the majority of actively managed funds underperform their benchmark....all that shows is that the majority of ratings should be neutral or negative and only a very select group of funds should get "metal" ratings.

In fact Morningstar themselves say that "metal" ratings are reserved for funds their "analyst team thinks have sustainable advantages that position them well versus peers AND A RELEVANT BENCHMARK on a risk-adjusted basis over the long haul." There is no way an index can have a sustainable advantage over the index it is tracking!!

By their own definition cheap index funds with the least sampling error should be able to get nothing higher then "neutral" since they define neutral as "Neutral: Fund that isn't likely to deliver standout returns, but also isn't likely to significantly underperform"

I talk about this here http://www.wallstreetrant.com/2011/11/are-morningstar-mutual-fund-analysts.html

[Allan_Roth]

I think you miss the point that Morningstar is predicting which funds will outperform their peers. The lowest cost funds are likely to outperform - hence gold. You use the wrong anchor by saying the index fund can't beat the index. The better anchor is that the index fund is destined to beat most investors.