Morningstar Inc. has announced a change to the methodology for its Morningstar Medalist Rating system that it says provides a more precise assessment of investment alpha. The change, which will take effect on Oct. 29, will alter the medalist ratings of about 20% of the 200,000 funds Morningstar has rated, with most of those changes downgrades. For example, Morningstar expects around 40% of funds currently assigned Bronze ratings globally will be assigned Neutral ratings after the change.
The change refines Morningstar’s framework for forecasting future returns but maintains the same process for assigning ratings. Using historical data, Morningstar said the updated framework introduces a more precise assessment of how much value a managed investment can add before fees compared to its assigned benchmark. Morningstar calls this piece the Alpha Potential Estimate.
According to an article from Morningstar Chief Ratings Officer Jeff Ptak explaining the change, he pointed to the current methodology leading to overestimates of “how much potential value a fund can be expected to generate before fees.”
It is replacing that methodology with an “approach that better accounts for the likelihood and magnitude of delivering positive value before fees,” Ptak wrote.
“While dispersion boasts simplicity and can convey useful information about the range of outcomes before fees, it can face drawbacks when the distribution of alphas skews negative,” Ptak wrote. “Specifically, in instances where there’s a wide dispersion of before-fee alphas but the median alpha is less than zero, a dispersion-based measure can lead one to overestimate how much potential value a fund can be expected to generate before fees.”
The Morningstar Medalist Rating is a five-tier system designed to evaluate an investment strategy’s potential to outperform a relevant index or peer group over the long term. Ratings are assigned on a scale from Gold to Negative based on evaluating how much value a managed investment can add compared to its assigned benchmark after fees and three pillars—people, process and parent—that determine Morningstar’s conviction in a particular investment strategy.
In a breakdown of the changes, Morningstar said 15% of the 200,000 funds will receive downgrades while 3% will receive upgrades. Among Gold-rated funds, 33% will be downgraded to Silver. Among Silver, 2% will be upgraded to Gold, and 38% will be downgraded to Bronze. Among Bronze funds, 2% will be upgraded to Silver, and 41% will be downgraded to Neutral.
After the methodology change, Gold, Silver, and Bronze ratings are projected to account for around 23% of rated global funds, compared with about 30% today. In his article, Ptak wrote that Morningstar expected allocation and equity funds to see more rating changes than fixed-income funds.
Morningstar assigns ratings in two ways: by analyst or by algorithm. According to Ptak’s article, Morningstar analysts assign ratings to funds they cover based on qualitative evaluations they conduct. The rest of the ratings are assigned via a machine-learning algorithm. Morningstar expects more changes to analyst-assigned ratings.
“The higher rate of change among analyst-assigned Medalist Ratings is largely explained by the distribution of ratings,” Ptak wrote. “Namely, Gold-, Silver-, and Bronze-rated funds constitute a larger share of Medalist Ratings assigned by analysts than they do Medalist Ratings assigned by algorithm, and we expect these higher-rated funds to see more changes than lower-rated funds.”
Morningstar is also refining the algorithm that evaluates the “process” pillar of passively managed equity vehicles that are not covered by an analyst. The updated approach will employ a rules-based system that more closely aligns with how Morningstar’s Manager Research analysts evaluate the process pillar of the ratings for these types of investments.
