Ratings are everywhere but when it comes investments, none have the cachet and history of Morningstar ratings.
Go to any mutual fund and chances are, if they have a good rating, they will tell you what their Morningstar rating is!
For example, Thrivent lists Morningstar ratings of their funds on the Fund Details page for one of their five-star funds, the Thrivent Mid Cap Stock Fund (TMSIX). Many mutual fund companies will have a page devoted to listing their Morningstar Ratings, such as this one by Dupree Mutual funds.
But what do these ratings mean? Are they handed out like Yelp ratings or is there more involved? Let's find out.
How do Morningstar Ratings Work?
Morningstar will give a rating to an investment based on their historic returns. These can include individual stocks but they are most often used when referring to a mutual fund.
For stocks, you're usually deciding whether or not you're investing in a specific company. There are a lot of company-specific factors to consider, the Morningstar rating is not going to play a big role.
However, if you're picking a mutual fund, there are likely several substitutes from other mutual fund companies. It's hard to differentiate between the various index funds that track the S&P 500 index. All the big companies, like Vanguard and Fidelity, have that index fund and your differentiator is typically the expense ratio and any tracking error. Here's where a Morningstar Rating can do some of the work for you.
There are two Morningstar ratings:
- Star rating – The star rating is used to compare an investment against its peers. Updated monthly.
- Analyst rating – The analyst rating is a “forward-looking assessment of a fund's ability to outperform its peer group or a relative benchmark on a risk-adjusted basis over a full market cycle.” (source) Updated at least every 14 months.
The star rating is the most popular one because you do not need a Morningstar Premium membership to see these ratings. (though if you need one, you'll want to see how you can get $100 off your Morningstar Premium subscription fee)
For a star rating, Morningstar looks at all the funds in the same Morningstar Category and rates the fund based on their “enhanced Morningstar Risk-Adjusted Return measure.” The rating is assessing the track record of the fund compared to its peers and will only rate a fund if it has a track record of at least three years.
The star rating is 1 (lowest) to 5 (highest) stars and is updated once a month. If the fund beats its peers, it'll get 4 or 5 stars. If it lags its peers, it'll get 1 or 2 stars.
Whereas the star rating tells you about the past, how a fund has performed compared to its peers, the analyst rating is Morningstar's attempt to be predictive about future returns.
Each fund is broken down into five pillars:
An analyst will use interviews with the team as well as proprietary data to establish a rating. The rating is based on the expectation of alpha, which is defined as “active return on an investment.” It's seen as what the manager brings to the table in terms of returns (ie. how much it beats its benchmark).
The Morningstar analyst rating has five levels with the top three having medals, here's what they mean:
- Negative (worst) – Expected negative alpha, net of fees
- Neutral – Expected zero or negative alpha, net of fees
- Bronze – The bottom 50% of investments with positive alpha, net of fees
- Silver – The top 35% – 50% of investments with positive alpha, net of fees
- Gold (best) – The top 15% of investments with positive alpha, net of fees
It is updated at least once every 14 months.
There are also two additional ratings that Morningstar will establish for funds:
- Morningstar Quantitative Rating – When there isn't an analyst covering a fund, Morningstar may still rate a fund using their Morningstar Quantitative Rating system. They use a “machine-learning statistical model” to establish a gold, silver, or bronze rating. The Quantitative Ratings are calculated monthly.
- Morningstar Sustainability Rating – This “is a measure of how well the holdings in a portfolio are managing their environmental, social, and governance, or ESG, risks and opportunities relative to their Morningstar Category peers.” The rating is a series of globes, 1 (low) to 5 (high) and is updated monthly
Vanguard Small Cap Index (NAESX) Report
I took a look at the report for the Vanguard Small-Cap Index Investor Shares (NAESX), which got 5 stars and a Gold rating as of July 10th, 2019. Remember, one of the rating criteria is Price and this report is based on the July 10th, 2019 price.
Here's the snapshot at the top:
Here is the Morningstar analysis of the five pillars:
I like that they make it clear the analysis was done on July 10th, 2019 (it's June 2020 when I write this). A lot of other reports would list a date at the top and never again, which makes it easy to think the rating applies to today when it's clearly almost a year old.
The real meat is the analyst report. The analyst for this one is Daniel Sotiroff, a manager research analyst for Morningstar, and the report is quite detailed. If you read this report, you will be more informed than your peers on what you're investing in. Some of it is just a “plain English” prose write up of what you'd find in a prospectus, others will give you context as to where it fits in versus their peers.
The second paragraph of the summary is a good example of this:
The fund tracks the CRSP U.S. Small Cap Index, a market-cap-weighted index that targets stocks landing in the smallest 85% to 98% of the market as ranked by market capitalization. Most of these small-cap names haven’t established durable competitive advantages and tend to be riskier than their large-cap counterparts. But this fund’s broad reach helps it effectively diversify firm-specific risk while accurately representing the small-cap segment of the market. Market-cap weighting relies on the information aggregated in stock prices to weight its holdings. Most of the time, the risks of portfolio concentration that may sully index funds are more than offset by the cost advantage and efficiency gained from market-cap weighting.
The bolded area is useful – now you know it invests in companies that are larger than the average small-cap but not the biggest ones. It's not a revelation though, you would know this if you knew about the CRSP U.S. Small Cap Index (and you knew what “this fund tracks that index” means). But it's convenient because it explains exactly what this fund invests in with just a single sentence.
The bolded section is useful because you may not know the strategy by looking at the list of top holdings of the fund (as of May 31, 2020):
- DocuSign Inc.
- Moderna Inc.
- West Pharmaceutical Services Inc.
- Leidos Holdings Inc.
- Tyler Technologies Inc.
- Coupa Software Inc.
- Zebra Technologies Corp.
- STERIS plc
- Teledyne Technologies Inc.
- Teladoc Health Inc.
Their analysis of the People pillar is useful because it gives you detailed information about the fund managers without you having to dig through the prospectus. It's not a make or break piece of information, it's usually the names of two people I've never heard of, but once you see a lot of these you'll recognize a pattern for various funds. Many of the fund managers have been there for years.
“Gerard O'Reilly and William Coleman share responsibility for this portfolio. Both became named managers on the fund in April 2016. O'Reilly joined Vanguard in 1992 and has served as a portfolio manager since 1994. Coleman has been with Vanguard since 2006 and has served as a named portfolio manager since 2013.”
28 and 14 years, respectively. That's a long time!
Also useful to know:
“Vanguard links manager compensation to operating efficiency, which helps keep costs low and aligns manager interests with investors'. Minimizing costs and tracking error are their primary objectives. Vanguard has automated much of this process and provides the managers with robust tools to handle flows, corporate actions, and benchmark changes.”
Again, not investment-changing information but it's nice to be able to read it all on a single page and leave feeling informed.
Shortcut by Using Morningstar Rating Lists
Now that you understand how the ratings work, here is how they become useful when you are an investor. You can start your search by filtering out funds that don't meet a certain Morningstar rating or Morningstar Analyst rating.
For example, their list of Medalist Funds are those who have earned a medal – bronze, silver, or gold:
Unfortunately, since the Morningstar Analyst Ratings require a Premium membership, you cannot see this list without a premium membership.
The star ratings are good for quickly assessing past performance and the analyst ratings will get you up to speed on the investment if you don't know anything about it yet, so these ratings do have value.
Do they result in better performance? The future is never certain but because of the five different factors in an analyst rating, it can give you a greater degree of confidence when you invest. Before you say confidence is just a feeling, remember that the best investors are those who can buy and hold for the long term. If you have greater confidence, you're less likely to sell an asset that underperforms because of external reasons.
If you think a fund is well run, low cost, and doesn't generate unnecessary taxable events; you're more likely to stick with it (because the alternatives that you'd invest in are worse, so where would the money go?). So confidence does matter and these ratings do give you a bit of that confidence.
Finally, Morningstar has been rating investments for a very long time and are very respected in the investing world. A rating doesn't guarantee better performance but if you want a rating, they are the ones to turn to.