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Ivanna Hampton: Welcome to Investing Insights. I’m your host, Ivanna Hampton. Morningstar stamps what it thinks about a fund’s future with this Medalist Rating. You’ve probably seen a star with the word Gold, Silver, or Bronze next to a fund you were researching on Morningstar.com. This represents the fund’s Morningstar Medalist Rating. The manager research team recently reworked and simplified how they judge funds to create a simpler process for investors to understand. The new methodology also brings more transparency and stability. Some funds’ ratings rose, while others fell or held steady. What were the key factors that led to the upgrades and downgrades, and which funds gained or lost status?
Morningstar Senior Principal of Ratings Russ Kinnel was in a room where it happened. Russ, who is also the editor of Morningstar FundInvestor, is here to talk about it.
Thanks for joining me, Russ.
Russel Kinnel: Great to be here.
Hampton: Your team recently underwent a big undertaking. What motivated you all to refresh the criteria for the Morningstar Medalist Ratings?
Kinnel: Well, we wanted to make it simpler and a little easier to understand for people, and we felt like there were some changes we could make under the scenes that would just make it a little better overall.
Hampton: Now, the previous system graded on a curve while trying to estimate a fund’s outperformance relative to its category. What are you all considering now, and why is it better?
Kinnel: We’re getting rid of that estimate of categories’ alpha, which looked at total returns and the variability of returns to kind of back into alpha. And it would also, as a result, we would give more slack on fees for the categories that we thought would have higher alpha potential and less slack to those that seem to have less volatile returns and therefore lower alpha potential. And now we’re getting rid of that, and therefore that’s kind of giving a more even playing field for all the funds.
Hampton: Are there any important distinctions between active and passive funds?
Kinnel: With passive, on the fundamental side, the rating is almost all process. It’s 80% process. And then fees are a higher component in passive because, of course, passive is all about low fees. So, there’s two main differences.
Hampton: The Morningstar Medalist Ratings are Gold, Silver, Bronze, Neutral, and Negative. Can you describe what happened when your team updated all the funds and their ratings at once? What categories saw gains and which saw losses?
Kinnel: So, big picture, I mentioned how volatility played a part in the old methodology. By taking that out, what that meant is some areas with a little less volatility, like bonds and balanced funds, gained ground. The biggest pickup of medals was in bonds and allocation funds. And then in equity was kind of a wash. Some parts of equities did better, some worse.
Hampton: And what about the equity style box categories?
Kinnel: Small cap, where there was greater returns volatility, had previously been given a fair amount of slack on fees. That slack was taken away. So, small caps generally lost some, went down in Medalist Ratings, and large caps went up a bit.
Hampton: And we’re going to review the ratings for three popular and large funds. First up is Fidelity Contrafund FCNTX. Why is it now rated Bronze?
Kinnel: We have an Above Average People and an Average Process, and that changed a little bit before the new methodology because Will Danoff, the longtime manager, is retiring at year-end. And so because of that, we took it down one notch, but it’s Bronze because it’s still a good fund. And I mentioned how large caps gained a little, and so that helped the fund to a Bronze.
Hampton: Next up, Pimco Income PONAX. It held steady with a Silver rating under the new criteria. Why?
Kinnel: Well, I mentioned also that bonds have done better, but Pimco Income retail shares are kind of pricey. Pimco is generally an institutional-focused shop. And so the institutions get a pretty decent deal. Individual investors, they kind of throw a bone. They don’t really give very good pricing. So, it’s a High People and a High Process, but the fees are not great, so that keeps it from getting to Gold.
Hampton: Your team calls Vanguard Total Stock Market Index
VTSMX
a one-stop shop for all US stocks. Can you talk about what boosted its individual share class from Silver to Gold?
Kinnel: The Admiral and institutional were already Gold, but the individual, because it cost a little more, had previously been a Silver, now it’s up to Gold. Again, we’re getting a little more slack in those large caps. And obviously, I think any of those options are really good. They’re all low-cost. You get a very broad diversification, so it’s an outstanding investment any way you look at it.
Hampton: Sticking with low cost, fees remain an important factor. How is the new approach benefiting target-date funds like American Funds 2030 Target Date Retirement AAETX?
Kinnel: One of the areas where I think our old methodology was pretty harsh was target-date funds, which to me are maybe the best mutual funds out there because they’re so well-diversified, well-run, and low-cost. So, we’ve seen a lot of funds, including American Funds, have gone up in the new scheme, and their absolute fees are very cheap relative to others, not that cheap, but we think the fundamentals at American are very good. They’ve really built up their team over the years so that you have good underlying funds, but you also have good glide paths, good management of the overall allocation. And so that popped American Funds up to Gold.
Hampton: And why were you pleased to see T. Rowe Price Floating Rate PRFRX climb a couple of notches from Bronze to Gold?
Kinnel: Floating-rate funds tend to have fairly narrow bands of returns. But our old methodology had been kind of harsh on them, and indexes don’t work very well for bank-loan funds because it’s a less-liquid area. Credit research is really valuable. And so it’s nice to see some of our favorite bank-loan funds popping up higher because I think they’re really good investments.
Hampton: Now another fund from that firm received a golden upgrade, T. Rowe Price Global Allocation RPGAX. Why did many allocation funds receive a significant boost?
Kinnel: Bonds and stocks, it’s sort of by design as you put them together, and you have more diversification, you have more relatively stable returns. You don’t have quite as much highs and lows as you would if you just had a pure equity fund. And so, the old methodology was kind of harsh on them. Now they’re elevating just like the target-date funds are. And again, I think these are really good for investors. We see when we look at Investor Returns that people do well with allocation funds and target-date funds because they’re kind of boring, they’re not that exciting. They don’t have the extremes that cause us to be either really greedy or really fearful and make too many trades. They’re easy for investors, and therefore, I think it’s great to see those Medalist Ratings reflect that.
Hampton: High fees knocked down some funds that were spared under the old system. Is that why Harbor Mid Cap Value HIMVX and LSV Small Cap Value’s LVAQX ratings dropped a notch?
Kinnel: They’re good fundamental funds, but their fees are not particularly great. And so that took some mid- and small-cap funds like them down a notch, depending on which share class you’re looking at.
Hampton: What’s the takeaway for investors researching funds on Morningstar.com and using the new rating system?
Kinnel: Well, I think the new system is easier to understand. It should be more stable, but also I think it really gives you good ideas that you can find Gold funds in just about any category. We mentioned how valuable I think allocation funds, target-date funds, and bond funds are. And so now we’ve kind of got more Gold-rated funds. So, we’re really highlighting the best opportunities in some of the best investment areas.
Hampton: Well, Russ, thank you for coming to the table and discussing the ratings refresh.
Kinnel: You’re welcome.
Hampton: That wraps up this week’s episode. Thanks for making this show part of your day. A couple of reminders: Give Investing Insights 5 stars on Apple Podcasts to help others find the work we’re producing for you, and subscribe to Morningstar’s YouTube channel to watch new videos from our team. Thanks to senior video producer Jake VanKersen. I’m Ivanna Hampton, editorial multimedia manager at Morningstar. Take care.
