Morningstar to Change Rating Methodology for Managed Investments

Morningstar Inc. has announced plans to change the methodology of its Morningstar Medalist Rating—a five-tier system designed to evaluate an investment’s strategy potential to outperform a relevant index or peer group over the long term.

The “enhancement,” as Morningstar terms the changes, which will begin to take effect on October 29 and involves changing the way Morningstar estimates how much value a managed investment can add before fees. As plan sponsors evaluate investment options to add to their plan menus, it is important they are aware of the change in Morningstar’s ratings if this is a benchmark on which they rely.

According to the announcement, the enhancement will “refine Morningstar’s framework for forecasting future returns,” but the firm is maintaining its same process for assigning ratings.

Jeff Ptak, Morningstar’s chief ratings officer, says the firm reserves its highest ratings for active funds that it believes are capable of delivering value to investors net of fees, adjusted for risk.

“We want to make sure that when we are assigning ratings to managed investments, we’re doing so in the most efficacious way possible because … it’s going to make the ratings more reliable,” Ptak says.

Specifically, Morningstar will begin subtracting a managed investment’s fees from the estimate of how much value the investment can add before fees. The difference, which represents how much value a managed investment can add after fees, will determine the Medalist Rating Morningstar assigns.

Ptak provided an example of how a fund might be impacted by the methodology change. If a fund was projected to have the potential to deliver 1.5% per year in value to investors before fees and adjusted for risk and charges a 1% expense ratio, the net value add to the investor after fees would be 50 basis points per year. But if Morningstar cuts its estimate of how much value the fund can deliver before fees from 1.5% to 0.75%, with the same 1% expense ratio, Ptak says now the fund cannot deliver any value net of fees.

With the new methodology, Morningstar expects about 20% of rated funds to see a rating change, and most of those will be downgrades. Gold, Silver and Bronze ratings are projected to account for about 23% of rated global funds, down from about 30% today.

Ratings are assigned on a scale that ranges from Gold (the top rating) to Negative (the lowest) based on an evaluation of 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 on a particular investment strategy.

Ptak adds that it is not unusual for Morningstar to update its methodology for ratings; it last made changes in 2019.

“We’re encouraged by what we’ve seen from the medalists ratings so far,” Ptak says. “It’s done a good job of sorting funds based on their future performance, but we aspire to an even higher standard.”

He adds that the types of funds that will likely see the biggest impacts from the methodology change are equity funds and allocation funds; fixed-income funds are expected to see fewer changes. Morningstar is moving away from an approach focused on dispersion and more on the “likelihood and magnitude of success,” he says.

“Allocation funds are funds that invest across multiple asset classes, but typically equities are the biggest sleeve in those types of strategies,” Ptak explains. “So even though they invest partially in fixed income, you are going to see a wider dispersion of outcomes in those than you would in a bond fund.”

Overall, Ptak says Morningstar expects to see higher-rated funds—those that earn the Gold, Silver or Bronze rating—to see more changes than lower-rated funds. With Gold-rated funds, Ptak says he is expecting around 40% of those to see downgrades as result of the methodology change.