A Share-Class-Level View of Our New Ratings

A version of this article first appeared in the November 2019 issue of Morningstar FundInvestor.

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We've launched enhanced Morningstar Analyst Ratings . You'll see that some funds already have ratings under the new system, and every new rating published from here on will use the new methodology.

The core idea of sorting out what funds can add value over the long haul on a risk-adjusted basis has not changed. Nor has the idea that fees, people, process, and parent are the key drivers in this fundamental outlook.

But we are getting more specific. Now we are attaching different overall ratings to different share classes of the same fund if we think the difference in price is meaningful enough to affect the likelihood of outperformance versus the benchmark. Prior to this updated methodology, we would rate funds based on their asset-weighted sales-channel ranking. In other words, if most of a fund's assets were cheap relative to their peer groups in similar channels, we’d be more likely to boost ratings, but if they were pricier, we’d lower them.

Now, we are rating each share class so that you can see which ones are worthwhile. More share classes have become available to more people, so we think it’s helpful to rate them all against each other. In order to get to that more-granular view, we estimate the potential for alpha in a category by looking at the historical dispersion of returns. That leads us to a pre-fee alpha estimate for the category. We adjust that up or down based on our view of the people, process, and parent of a fund.

Then we subtract each share-class expense ratio from that figure to arrive at a separate overall rating for each share class. In a category with a modest alpha estimate, a fund with some positive attributes might see a wide range of ratings. In other areas, where fees are uniformly high or low for a fund or where alpha potential is higher, a fund's ratings are likely to be limited to one or two levels.

So that it’s more apparent how we arrived at the ratings, we are getting more granular by breaking out our pillar ratings into five levels rather than three. Our new scale is Low, Below Average, Average, Above Average, and High. You can see a fund’s pillar ratings in the middle of the quote page for that fund.

To show you how the new ratings work on a share-class level, we've made some graphics of funds rated under our enhanced system.

New Ratings Examples We rate JPMorgan Government Bond OGGAX Above Average for Parent, People, and Process. Because government-bond funds have tightly packed returns before fees, our model assigns a low alpha potential. That in turn explains why ratings for the share classes span all the way from Neutral to Silver. The share class charging 0.35% received a Silver rating. The share classes with a 0.48% fee and a 0.60% fee were in the second-cheapest quintile and got a Bronze. Those charging from 0.75% to 1.40% received Neutrals. That might seem like we are slicing it awfully close, but past returns illustrate the point. Only those two cheapest share classes beat the fund's benchmark return of 2.9% over the five years ended September 2019, and the two share classes charging more than 1.00% were the only ones to lag the benchmark return of 3.0% over the past 10 years. That's hindsight. So, while not a claim of ratings success, it is an illustration of why fees are especially important in lower-returning asset classes.

- source: Morningstar Analysts

For a contrast, let’s look at a fund in one of the categories with high return potential. Vanguard International Explorer VINEX plies its trade in foreign small/mid-growth. It’s a category with lots of alpha potential. However, this fund is almost an index fund with very low costs, three subadvisors, and many holdings. Thus, we have People and Process at Average but a High rating for the Vanguard Parent. (Very few fund companies rate a High in our book.) Now, we combine that information with a super-cheap expense ratio of 0.39% and end up with a Bronze rating. With fees so low, it didn’t take much to get the fund into Morningstar Medalist territory.

Franklin Small Cap Value FRVLX also benefits from a generous alpha assumption. Last time, we rated it Above Average for Process but Average for People and Parent. Overall, we gave it a Neutral. We maintained those pillar ratings; however, under our enhanced system, its fairly cheap R6 and Adv share classes, charging 0.62% and 0.80%, respectively, get Bronzes. However, the A, R, and C share classes get Neutrals because they charge 1.05%, 1.30%, and 1.80%, respectively.

- source: Morningstar Analysts

Pimco International Bond (USD-Hedged) PFORX is another interesting case. It rates Above Average for People and Parent, but High for Process. Pimco likes to give institutional investors a good deal and retail investors a kind of lousy deal. As a result, the four cheapest share classes were rated Gold, while the next two were rated Silver. On the downside, the dismally priced C shares get a Bronze for charging 1.70%.

- source: Morningstar Analysts

High-yield funds have a higher estimated return than most bond funds. But a fund designed for advisors with some fairly high fees is not going to fare so well. Fidelity Advisor High Income Advantage FAHDX has Above Averages for all three pillars but only gets a Bronze for second-quintile fees. Fees in the third to fifth quintiles get Neutrals.

MFS Technology's MTCAX ratings barely change even though it is in a high-return category. That’s because its fees range from the second to fifth quintile. Also, it rates an Average for Process, which holds it back despite getting Above Average for People and Parent. Its share classes between 0.89% and 1.48% get Bronze ratings, but it has three share classes with super-pricey 1.98% expense ratios that get much deserved Neutrals.

- source: Morningstar Analysts

American Century Short Duration ASHHX shows that if you have a pricey fund in a low-return category, the floor is Negative--not Neutral. The fund rates an Average Process, People, and Parent. Shares charging between 0.34% and 0.84% rate a Neutral. Those charging between 1.09% and 1.59% rate a Negative. Had you owned the 1.59% share class the past 10 years, you’d have netted a meager 0.77% annualized return.

- source: Morningstar Analysts

The allocation--30%–50% equity Morningstar Category has middling return assumptions. We can see that in the case of Hartford Balanced Income HBLAX, which has three Above Average pillars. However, its fees are all over the map, so ratings go from Neutral to Silver. (It had been rated Silver in our old ratings format.) The fund's share classes in the cheapest two quintiles (0.57%-0.68%) get Silver, the middle quintile (0.90%-0.98%) gets Bronze, and fourth quintile (1.28%-1.65%) gets Neutral.

- source: Morningstar Analysts

Fundamentals still drive our ratings as they did before, but we are elevating fees in our process as they are the best predictor of future returns. We'll gradually bring all of our ratings under the new umbrella over the coming year. We'll continue to explain the process and any changes that happen to our ratings.