Investment research house Morningstar has announced plans to apply its forward-looking analyst rating to exchange-traded funds (ETFs) globally, allowing investors to more easily compare investments across fund types.
Hortense Bioy, Morningstar’s Director of European Passive Funds Research.
With rollout anticipated later this year, Morningstar will initially assign ratings to approximately 300 ETFs, of which around 100 will be domiciled in Europe, with coverage expected to expand over time.
The Morningstar Analyst Rating is a qualitative rating system based on research from Morningstar’s team of fund analysts. Morningstar has approximately 115 manager research analysts worldwide and the company provides data on approximately 13,900 exchange-traded product listings (as of 30 June, 2016).
The ratings system displays analysts’ conviction in a fund’s ability to outperform its relevant peers on a risk-adjusted basis over a full market cycle. The system follows a five-tiered scale: Gold, Silver, Bronze, Neutral, and Negative, with analysts arriving at a rating through an assessment of five key pillars: process, performance, people, parent, and price.
Hortense Bioy, Morningstar’s Director of European Passive Funds Research, commented: “With ETFs increasingly used strategically to build investment portfolios and the range of ETF options continuing to grow, investors need help to make informed decisions. We’ve been providing qualitative research and analyst reports on some 650 ETFs worldwide for more than eight years, and launched Analyst Ratings for index funds in the UK in 2013. Assigning the qualitative Morningstar Analyst Rating to ETFs is a natural extension of our research intended to further support investors in their due diligence efforts.”
The underlying methodology includes a comparison of risk-adjusted returns and adjustments for fund expenses. This means the more expensive the fund is, the harder it will be for the fund to earn a high star rating. (For a detailed description of the Morningstar Ratings methodology, click here)
Every fund is rated versus its category peers over three discrete periods: three years, five years, and 10 years. Funds are rated on a curve, with the top 10% and bottom 10% of risk-adjusted performers in each category receiving one star and five stars, respectively. The next 22.5% at each end of the scale receive two stars and four stars, respectively, whilst the middle 35% receive three stars.
The final rating is a weighted average of the rating for all three periods. In keeping with the view that funds are long-term investment vehicles, the final rating puts the most emphasis on longer time periods. For a fund with 10 years of history, Morningstar puts 50% of the weight on the 10-year period, 30% on the five-year period, and 20% on the three-year period. For a fund with five years of history, Morningstar puts 60% of the weight on the five-year period and 40% on the three -year period.
By placing emphasis on long-term performance, the methodology helps investors avoid funds with alluring short-term performance but poor long-term records.
While the ratings system provides an easy-to-use, quick comparison between similar funds, investors should be cautious in using the ratings as their sole basis for investment decisions due to certain limitations of the system.
Firstly, a high rating isn’t a guarantee that a fund will be a solid performer. A fund may very well have a 5-star rating because of its impressive historical record, but, as performance-chasers often find out the hard way, the past doesn’t reliably predict future returns.
Secondly, the subjective nature of analyst expectations should always be taken into account. Morningstar notes that analyst ratings are based on current expectations about future events and therefore involve unknown risks and uncertainties that may cause events to differ significantly from Morningstar’s expectations.