Morningstar Ratings – Are They Meaningful?

Daniel Penzing
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How Does Morningstar Figure Its Ratings?

Good Morningstar Rating Confuses Investors!

I am a big fan of Morningstar analyst ratings, especially the rating system. But this latest Morningstar rating update is a mess and only an example of how Morningstar confuses investors!

I will be discussing this at length in another post.

I was amazed when I learned how Morningstar had raised the ratings of private equity funds, REITs and MLPs when interest rates were headed up!

Most of the funds labeled 4 STARS or above in Morningstar received this ranking between January 2013 and January 2016.

That period marked the low in interest rates, when interest rates had peaked, were falling for a year and a half, or had hit the bottom towards the end of 2015.

This is amazing when Morningstar usually is conservative when it comes to interest rates.

This is also strange since the funds subject to these ratings had low bond holdings and were not adjustable rate mortgage, mREITs, or high yield funds, which tend to do well in the rising treasury environment.

Then compare that to the high incidences of downgrades when interest rates were rising!

Investors should be confused by this stuff!

Private equity funds are not automatically safe from interest rate hikes, and can easily lose money in an interest rate hike cycle, despite the great fund ratings when rates were going down!

Past Performance and Future Results

Morningstar ratings are like those of other brokers: No one can say for sure whether they’re meaningful or not.

To be fair, the Morningstar ratings are a lot better than most of the garbage you see on the Internet. Nobody trusts your review. I don’t trust your review. So people use Morningstar.

They do have the advantage of being “official,” although that has its downside too. Some people think that if a fund has a three-star rating, it means it might be worse than an identical one with a two-star rating.

So, according to Morningstar itself, the ratings should be used this way:

Could Expense Ratios Be More Meaningful?

Morningstar ratings evaluate past performance and involve a great deal of judgment and opinion. Expense ratios are a more direct measure of past performance, not subject to subjective judgment. Expense ratios are also more comparable across funds.

Morningstar ratings are affected by the performance of the indexes on which the fund is rated. Funds that are rated on the S&P 500 index are likely to have more money invested in them than those that are rated on small cap growth indexes. This will raise the price of the small cap fund and lower the price of the S&P 500 fund.

Since the expense ratios for the S&P 500 fund are the same as every other fund, the fund that gets the most money is likely to have the highest expense ratio. In contrast, the expense ratios of a small cap fund are likely to vary depending upon how much money is invested. The greater amount of money invested translates to a lower expense ratio.

Many funds have weighting adjustments that carefully follow the indexes on which the fund is rated. For this reason it is better to compare funds based on indexed returns rather than on star ratings.

Bottom Line

Looking over the backhaul facility ratings seems a bit confusing so it is helpful to know how Morningstar – how these stocks were rated and what the ratings mean:

Morningstar rates stocks with A, B, C, D and F letter grades. Only one stock gets an A? So the ratings with many news agencies are relative based on how stocks performed in that sector compared to other stocks in that sector. This includes – what stocks in a sector did not do well but also includes which stocks up significantly.

For instance, stock A in one sector may not have done that well and would be graded as C when compared to other stocks in that sector, but it did significantly better than stock B which was graded a D. So although stock A gets a C rank, it has performed better in its sector compared to a D ranked stock.

The letter grades are relative and not like A being the absolute best. This is a difficult concept to understand the first time you see these ratings as the grades are all over the place: A being the best and F being the worst. The letter grades are relative to each sector once graded. The letter grades also do not include the stocks not performing in the sector compared to the outperforming stocks.

This graphic is from Morningstar and should give you some insight on how to interpret these ratings.