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Morningstar 7-page ‘forward looking’ Analyst Reports

Morningstar’s recently launched 7-page Analyst Reports offer fund ratings based on qualitative forward-looking judgement and complement the firm’s ‘star’ ratings, says Oliver Kettlewell, senior investment research analyst at Morningstar

Morningstar is perhaps best known for its “star” ratings, officially branded as the Morningstar Rating. These ratings rank funds from one to five stars based on past performance and risk. It is an intuitively easy rating for investors to understand; the higher the rating, the better a fund’s historic risk-adjusted returns. Screening funds for a high Morningstar Rating is a useful tool for fund selectors who need to narrow down thousands of funds to a workable list.

However, past performance is no guarantee of future success and therefore a useful complement to the Morningstar Rating is the Morningstar Analyst Rating. As its name suggests, the rating is determined by a Morningstar analyst rather than a computer. The analyst utilises qualitative, forward-looking judgement in order to assign a rating.

Analyst Ratings of Gold, Silver or Bronze means Morningstar analysts expect a fund to outperform a relevant benchmark over a full market cycle of at least five years. Ratings of Neutral and Negative suggest in-line returns or underperformance, respectively. The Analyst Rating is determined by analysing a fund based on five pillars—Process, Performance, People, Parent and Price—and the rating is supported by a seven-page report detailing the rationale for each pillar and a summary opinion of the rating.

Easily digestible information

The seven-page report details our opinion of a fund’s merits, but broken down into bite sizes to make it easier for the reader to digest. For example, the first page summarises our rationale for a fund’s rating based on the five pillar scores. It also contains performance graphics and portfolio data. Readers who want more insight into the fund’s performance history or investment style can turn to the “performance” or “process” pillar pages, respectively.

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The process pillar assesses a fund’s strategy. We seek to ascertain whether a fund’s management has a competitive advantage enabling it to execute the process well and consistently over time. We form our opinion based on meetings with the fund manager in addition to analysing a fund’s holdings data to ensure that the manager’s portfolio is consistent with the professed strategy. Much of the holdings data which forms our assessment of a manager’s process is spread across the second and third pages of the report’s process pillar. Factors include the fund’s market-cap, value and growth style factors in addition to sector and stock holdings.

The second pillar, performance, is the only pillar to overlap with the star rating. However, rather than look at past returns, we assess a fund’s performance profile given its stated process, in order to help set investors’ expectations of the fund during different market environments. For example, an aggressive small-cap fund investing in high-growth yet high-risk companies is likely to have a volatile performance profile, outperforming during bull markets, but losing more than its peers in a falling market. Such a performance profile can result in a positive Morningstar Analyst Rating provided the fund can outperform over a full market cycle. The performance page of the report shows past returns and a fund’s maximum drawdown (its peak to trough loss during a market cycle), but past performance is combined with forward-looking written commentary on the fund’s likely performance profile in a given market environment.

People and parent pillars

The people pillar is unsurprisingly concerned with the people behind the fund and therefore meetings with the fund manager are once again utilised. We determine whether a fund manager has sufficient and relevant experience for a fund’s mandate and evaluate the level of analyst support. The people page of the report states the years of management experience and the number of managers running the fund. But this data is only important in relation to the stated process. For example, a global equity fund managed by a single manager may seem under resourced on paper. But if the manager is applying a quantitative process to select stocks then there is less need for a big analyst team. The quant model does much of the heavy lifting ordinarily undertaken by stock analysts. In contrast, a larger team would be needed for fund managers applying bottom-up, research-intensive approaches.

Parent is the only pillar not directly related to a fund. This fourth pillar is a group-wide assessment of an asset manager. The parent page states the proportion of a firm’s funds holding a Morningstar Analyst Rating, the size of the firm’s largest funds and the amount of assets dedicated to the major asset classes of equity, bonds, commodities and property.

The fifth and final pillar is price which evaluates whether a fund’s fees are low enough for it to outperform its peers. Our studies have shown that fees are one of the best indicators of a fund’s future performance. Below-average costs give a fund manager an automatic head start over peers’ by lowering the hurdle a manager has to overcome to beat the benchmark. The price page states how much a fund costs in absolute terms and, more importantly, relative to its peer group.

Our five-pillar approach to rating funds has not been designed to serve as a formula, but as a robust analytical framework ensuring consistency across Morningstar’s global coverage universe. The Analyst Rating is intended to supplement investors’ and advisers’ own work on funds. The research reports outline the rationale for a rating and, more importantly, outlines how a fund is likely to behave from a forward-looking perspective.

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