For those who vigilantly monitor the fund ratings issued by Morningstar, upcoming changes to its vaunted medal-themed system should be of interest. Among advisors and asset managers, the moves could be particularly impactful.
After the move set to take effect later this month, strategies will be assessed based on whether they’re hospitable to active management, reported the Wall Street Journal. But more importantly, mutual funds and ETFs will be given Gold, Silver, Bronze, Neutral, and Negative ratings based not just on whether they beat their peer groups, but also on the likelihood that they’ll beat an index.
“[M]any investors have shifted from investing in actively managed funds that invest in similar stocks to investing in low-cost ETFs that accurately track the same stocks,” said Wall Street Journal contributor John Coumarianos. “A peer group alone is thus an inadequate point of comparison for an active fund.”
Medal considerations will also be made independently for different share classes of the same fund. That tweak to Morningstar’s rating system was made in recognition of how prices of different share classes can impact returns for investors — a distinction that the system previously didn’t account for.
As Coumarianos explained, a hypothetical bond fund could have multiple share classes and a wide diversity of fee structures. Under the current system, each share class could have a different star rating based on its past volatility-adjusted returns, but still have the same medal rating of Gold based on their prospects for beating peers and an appropriate benchmark index.
But the picture changes when expense ratios are accounted for. If certain share classes of the fund come with expense ratios above 0.7%, and the yield on one of the bond fund’s holdings is 1.6%, that means a large chunk of yield is lost to expenses. The same logic applies to other bonds that the fund might hold.
“A medal-ratings reassessment for such a fund’s most-expensive share classes, given their dimmer prospects for beating the relevant index, would appear possible in such a case,” Coumarianos said.
Because of the more nuanced ratings given to fund share classes, asset managers face a stronger incentive to take a hard look at the fees they charge for higher-cost share classes, and slash them if they’re not competitive.
“[I]t also means there could be additional pressure for financial advisers to lower fees,” he added. C-class shares,or adviser-class shares, tend to have relatively high expense ratios because of a typical 1% advisory fee that’s included. A change in the medal rating of that share class, however, could make it harder for advisors to use in client portfolios.
Should the use of adviser share class units become harder to justify, Coumarianos added, we could see an acceleration in the shift toward fee-based financial advice and the use of index funds. “1% for an adviser’s services is more palatable to a client if the funds that the adviser uses charge 0.05% or 0.15% instead of 0.50% or another 1%,” he said.
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