At the end of October, Morningstar implemented a change to the Morningstar Medalist Rating assigned to mutual funds, exchange-traded funds, and other managed investments. Around 15% of ratings changed overnight -- and most of those changes were downgrades.
As before, only those funds that Morningstar expects will add value for investors, after fees, can earn one of the three highest ratings. The ratings tiers -- Gold, Silver, Bronze, Neutral, and Negative -- have done a good job predicting differences in funds' future performance, with higher-rated funds faring better than lower-rated funds, on average. In other words, Gold funds have tended to outperform Silver, and so on.
But the ratings weren't as successful at singling out funds likely to outperform their benchmark indexes. So, Morningstar raised the hurdle, by lowering the estimates of how much potential value a fund can add. This makes it harder to earn the highest ratings -- but also improves the likelihood that the highest-rated funds will outperform their benchmarks going forward.
According to Morningstar's chief ratings officer, Jeffrey Ptak, "The epicenter of ratings changes is actively managed US stock funds, especially those that had been rated Bronze, Silver, or Gold." That's because it's challenging for active managers to outperform the highly efficient US market, particularly after expenses.
"It stands to reason," says Ptak, "that all things being equal, fees become more important." In other words, the higher a fund's expense ratio, the harder it is to earn a high Medalist Rating.
Take a look at T. Rowe Price U.S. Equity Research Fund, a $13 billion fund in the competitive large-blend Morningstar Category. The table below shows the ratings before and after the change. Note that each share class of the fund has its own rating because each share class has a different expense ratio. The table ranks the classes by fees -- and the new Medalist Ratings line up accordingly.
Under the old system, three of the four share classes had Gold ratings: the standard retail shares (T. Rowe Price U.S. Equity Research PRCOX), the advisor shares (T. Rowe Price U.S. Equity Research Adv PACOX), and the institutional shares (T. Rowe Price U.S. Equity Research I PCCOX). After the update, only the institutional share class -- the cheapest of the lot -- is rated Gold. The retail shares are now Silver-rated, and the advisor shares moved down to Bronze. The most expensive share class, the retirement class (T. Rowe Price U.S. Equity Research R RRCOX), was downgraded all the way to Neutral from Silver.
Even after the downgrade, however, three of this fund's four share classes still earn the higher-conviction ratings. Their expenses are relatively moderate, as is usually the case with T. Rowe Price. They are also backed by Parent and Process Pillar ratings of High and a People Pillar rating of Above Average. These three pillars are the backbone of the Medalist Rating calculation.
On the other hand, funds that are merely Average on these three pillars now have a harder time earning even a Neutral rating if they charge steep fees.
Consider Franklin DynaTech, one of the larger active funds in the large-growth Morningstar Category. Before the ratings enhancement, all five of its share classes earned Neutral ratings. After the change, the pricey C share class (Franklin DynaTech C FDYNX) dropped to Negative. Similarly, Edgewood Growth's retail share class EGFFX was downgraded to Negative, while the less-expensive institutional share class EGFIX maintained a Neutral rating.
A downgrade does not mean shareholders should automatically sell a fund. (For one thing, there may be tax consequences from trading in a taxable account.) As with the T. Rowe Price example above, a downgraded share class may still be a good prospect for outperformance going forward, even if it doesn't meet the more exacting standards required for the highest rating of Gold. After all, most investors will not be able to pony up the $500,000 minimum required for the Gold-rated institutional share class. Even shareholders in the now Neutral-rated retirement share class may find they are best served by this option among their range of choices in their 401(k) plan.
That said, the enhanced rating is a great reminder of how expenses detract from an investment's chances of outperforming. Investors who have more than one way to access a fund should choose a share class carefully to improve their odds of success.
The October implementation of the enhanced rating methodology affected primarily those funds not covered by Morningstar's analysts; these ratings are assigned by algorithm and updated monthly. The enhanced rating will be incorporated more gradually for analyst-covered funds. Analysts update their ratings every 14 months or so as part of their regular coverage schedule, so it will take around a year for this enhancement to be fully reflected.
A separate adjustment to the Medalist Rating calculation affected the Process Pillar ratings for equity index funds that aren't covered by Morningstar's analysts. This change also led to some ratings changes. For example, the popular Vanguard Information Technology ETF VGT dropped to Bronze from Gold. Again, a downgrade isn't a sell signal: A low-cost index fund like Vanguard Information Technology ETF that was appropriate for your portfolio before the change likely remains a solid choice.