Active funds most vulnerable as Morningstar overhauls rating system

Ratings provider is paying more attention to fees in global shake-up

Fund downgrades will outnumber upgrades by two-to-one as part of Morningstar’s global revamp of its rating system with active funds most vulnerable.

The research firm unveiled how it is reorganising its forward-looking fund ratings methodology and the main takeaway is that fees will carry a more significant weight in analyst ratings than in the past. The changes were first announced in July but further details were revealed this month.

“We’re setting a higher bar for actively-managed funds,” said Jeff Ptak (pictured), Chicago-based global director of manager research, who spoke at a Hong Kong media briefing attended by Portfolio Adviser sister publication Fund Selector Asia.

“The more fee running through a fund, the harder it’s going to be to get a gold, silver or bronze rating.”

The rating scale is not changing, but the process by which an analyst arrives at a rating is.

Previously, the firm used five pillars to generate a forward-looking fund rating: people, process, parent, performance and price.

The new methodology will fold performance into people and process and together with parent, there will be three pillars with the following weightings:

Actively-managed funds (includes strategic beta)


Index funds


Fees will be a swing factor, subtracted from the preliminary result to determine the final forward-looking rating.

Notably, fees will now apply across share classes of an individual fund. Share classes tend to have different fees – typically lower charges for the institutional share class and higher for retail. With fees the determinant, each share class of a fund could have a separate rating, based on price.

Additionally, Ptak said that the asset management industry will be able to infer what the value-add is for investment styles.

“It will be no leap to know what the maximum charge is that can be levied,” he said. “Suppose in a given fund category, a skilled active manager could deliver 100 basis points in pre-fee alpha. If you’re charging more than 100 basis points, you’re under water.”

The new methodology will apply globally across the roughly 3,800 funds Morningstar covers. As a rough estimate, the number includes 3,500 active funds, which includes strategic beta, plus 300-400 passive funds, Ptak said.

The changes will take at least one year, he added.

‘Clear link between fees and performance’

The firm’s fee emphasis is in line with global trends. Global inflows into low-fee passive products are on an upward trajectory and in the US, passive assets for the first time exceeded active fund assets this year. Meanwhile, high fee active funds that hug the benchmark are being outed by research and losing assets.

Morningstar has long maintained there is a “clear link between fees and performance” and the charges for funds are the most reliable indicator of future performance across asset classes.

In a 2016 study, the firm found that the cheapest-quintile equity funds were three times as likely to succeed as the priciest quintile, a result that was similar across asset classes.

“Firms with high fees are unlikely to offer above-average performance. Low-fee funds give investors the best chance of success over the long term,” the report concluded.

Ptak said so far the industry “is in a wait-and-see mode”.

“[The ratings revamp] has elicited reactions from some with ‘particular business models’ and also distributors,” he said.

“We’re being transparent saying that fees matter and it’s enshrined in our methodology. It’s up to the industry to decide how to receive this and what conclusions to draw from it.”

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