Will Morningstar's New Analyst Ratings Help You Pick Winners?

[This post was updated June 11, 2011]

The mutual fund rating company Morningstar announced plans last week to do what many investors thought they were already doing: naming funds that will outperform. The new Morningstar Analyst Ratings, to be introduced in September, will supplement the widely followed--and widely misused--star rating. Unlike the star ratings, which measure past performance only, the new system will try to rank the funds of the future. Since that's what you really want to know, after all, you're likely to find the new ratings more useful than the star system. But Morningstar may find that predicting the future is a pretty tall order, even for them.

The star ratings, you'll remember, award funds one to five stars (five being best), based on their past performance, adjusted for risk. Investors and fund companies alike treat a high Morningstar rating as an honor somewhere between canonization and a Nobel prize. Fund companies with high ratings brag about the fact in their advertising, and 90% of the money investors put into funds goes into those with four or five stars.

The only problem is, star ratings, like any other measure based on history, tell you little about future returns, as CBS MoneyWatch writers like Nathan Hale, Larry Swedroe and Jane Bryant Quinn have repeatedly pointed out. Morningstar's own director of fund research, Russel Kinnel, admitted last summer that a low expense ratio was a better predictor of future success than a high star rating.

The new system aims to produce a more reliable window on the future. The system awards funds one of five grades: AAA, AA, A, neutral, or negative. To arrive at those ratings, analysts weigh the funds' past performance and risk, its price, the record and tenure of its managers, and the culture and resources of its parent company. Funds will be rated in comparison to their peers. "An analyst rating is not meant to predict, say, that emerging markets are going to do better than U.S. blue chips," explained Morningstar managing director Don Phillips. "It's not a market call."

Now, partly quantitative, partly subjective evaluation is nothing new to Morningstar. The company already offers something like it to employers and institutional clients looking for advice on funds for 401(k)s. And the new analyst ratings aren't all that unlike Morningstar's existing premium Analyst's Picks, which Morningstar's records show have done a better job predicting performance than the star ratings. What is different is that the new analyst ratings will be available free on Morningstar's public Website. (Come September, you'll still have to be a premium subscriber to get a detailed look at the reasoning behind a rating.) Morningstar has a tradition of democratizing mutual fund information, and free analyst ratings are in keeping with that.

Phillips points out that the new rating system gives Morningtar researchers the freedom to incorporate factors that correlate with future returns but aren't included in the star ratings, such as whether a fund's managers own shares themselves. The ratings will also factor in Morningstar's evaluation of how well the fund company tends to look out for shareholders. That's also an improvement. Good or bad "stewardship," as Morningstar calls it, may not directly affect performance, but it can tell you whether the people running the fund care more about their bottom line than yours.

Predicting the future is still going to be tough, however, let alone slicing it into AAA, AA and A tranches. Markets change, fund managers lose focus, funds can grow too large to manage--and all of that is hard to foresee. Besides, even if Morningstar is right on most of the 1,500 or so analyst ratings it eventually plans to hand out, you're never going to buy more than a handful of those funds. You'll never know until years later whether they were the ones Morningstar got right.

So rather than taking the letter grades too literally as a forecast of return, you might best think of A-rated funds as "funds that are likely to treat you fairly," or "funds with no obvious impediments to success," or "funds that follow best practices."

That may sound like faint praise, but it's more than the star ratings alone tell you now--and far more than anyone other than Morningstar will tell you about funds, particularly for free. But it's still less than a crystal ball. As one fund pro said the day of the announcement (he asked not to be named because Morningstar rates his company's funds), "Morningstar analysts do thoughtful research, but I don't think they've become oracles overnight."

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