Morningstar overhaul will give, or take, stars

Your Funds

Dollars & Sense

May 05, 2002|By CHARLES JAFFE

MORNINGSTAR has announced that it will completely overhaul its ubiquitous star-ratings system, beginning in July.

Hundreds of mutual funds will gain or lose valuable stars without any change in investment performance. It's a confusing development that, in the end, will not only improve the system but also benefit those who rely on the star system without understanding it fully.

That group includes most fund investors. According to Financial Research Corp. in Boston, funds with four- and five-star ratings from Morningstar gathered $119 billion in assets last year, while funds with lower ratings shrank by $79 billion in net redemptions.

Funds in a broad category - such as domestic stock funds - are lumped together and ranked by "risk-adjusted return" over the past one-, three-, five- and 10-year periods.

Risk-adjusted return is a measure of what a fund gained compared to the risks it took. A highly conservative fund that achieves average results while limiting volatility is likely to get a higher rating than a speculative, jumpy fund that also produces average returns.

Stars are awarded on a bell curve, so that the top 10 percent of funds in a category get five stars, the next 22.5 percent get four stars, the middle 32 percent three stars, and so on.The biggest flaw currently is that funds with different objectives are measured against each other, so that small-cap value funds are lumped with large-cap growth funds.

The result is that top ratings tend to go to funds in whichever sector is hot.

That's why nearly half of small-cap value funds, which were beaten down during the bull market of the late 1990s, carry a five-star rating. By comparison, just five large-cap growth funds still carry the highest rating, despite that category's particularly robust gains during the bull market.

Top-rated funds, therefore, have tended to come from hot market areas, which makes over-reliance on the ratings a blueprint for disaster. By the time a category gets hot enough to dominate the top ratings, it often is ready to cool down. That flaw prompted Morningstar's launch of "category ratings" in 1996, aimed at comparing funds with their peer group. This allowed an investor to determine, for example, which five-star small-cap value funds are best, and which are only average.

Many financial advisers emphasized category ratings over stars, considering it more important for an individual to develop an asset allocation than to chase performance by buying only top-rated funds.

That kind of criticism spurred Morningstar's changes.

The new format eliminates category ratings entirely, and bases performance stars on a fund's narrow asset class rather than broad investment categories.

As a result, only 10 percent of those small-cap value funds will be able to get a five-star rating. The rest will lose stars. And many funds in out-of-favor sectors such as large companies or technology will gain stars.

"In the past, any fund that had a five-star rating had dazzling return numbers," says Morningstar Managing Director Don Phillips. "Now there will be some five-star funds with pedestrian overall returns, but that stand out as the best in their category. And there won't be so many mediocre funds getting five stars because the market is carrying them along."

While Morningstar has not released the new ratings yet, its tests indicate that the system should be more stable, with fewer swings in a fund's stars. That means that once the initial shifting of stars from the old to the new style is complete, a ratings change is likely to be more meaningful, a much bigger flag about trends in a fund.

Financial advisers and fund companies are just learning about the new ratings system, but seem to view it as an improvement. Ideally, as far as Phillips is concerned, it will make ratings more reliable, meaning the investment public that has used them as a crutch will be leaning on a better tool.

"The data says that people already rely on stars, whether that is the right thing to do or not," says Phillips. "If a five-star rating will now be more reflective of manager skill and factors like expenses - rather than the luck of investing at the right place and time - it should make the ratings more useful."

Chuck Jaffe is mutual funds columnist at The Boston Globe. He can be reached by e-mail at jaffe@globe.com or at The Boston Globe, Box 2378, Boston, Mass. 02107-2378.

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