Upcoming changes to Morningstar’s fund rating methodology could see 20% of funds have their rating altered – the vast majority of which (85%) will likely be downgrades.
The firm is keeping its existing criteria, but will now also take a fund’s ongoing charges into account. When it comes into effect on 29 October, the new methodology will subtract a fund’s fees from the estimated value it can add before charges.
This new approach – which will analyse a fund’s pre-fee alpha versus its assigned benchmark to ascertain the value its management is adding – is intended to give investors a better understanding of where they are getting the best value for money when it comes to charges.
In a statement the firm explained: “The current approach has been reasonably accurate in forecasting how much value managed investments generate before fees. But its reliance on the dispersion of pre-fee alpha (as represented by the semi-interquartile range of historical pre-fee alphas) doesn’t fully take the shape of the pre-fee alpha distribution into consideration, which can detract from the forecasts’ precision when the distribution is skewed.”
See also: Morningstar: August selloff should highlight the importance of portfolio construction
Morningstar expects the amount of funds with the top ratings – gold, silver and bronze – to drop from 30% to 23%, whilst those with the worst rating – neutral or negative – will increase from 70% to 77%.
These changes mark a “significant” shift in its methodology that will make ratings more competitive, but it is intended to ultimately give investors a better knowledge of which funds are worth their fees, Morningstar added.
“We’re making this change because we believe it will yield more accurate estimates of how much value managed investments are likely to generate before fees,” it said.
“This should make the Medalist Rating more effective in forecasting future returns and, in turn, help investors who use the Medalist Rating to achieve better outcomes.”
