Founded in 1984, Morningstar has grown from a startup to a global research company in 35 years. A 27-year old stock analyst , Joe Mansueto thought it was unfair that people didn’t have access to the same information as financial information as financial professionals. So he hired a few people and set up shop in his apartment to deliver investment research to everyone.
Now it has established its foot prints in 27 countries with an employee base of about 6700 at the end of 2019. The increase reflects continued investment in resources to support key growth initiatives, including operations in India and the United States. This increase also includes approximately 504 employees who joined Morningstar as a result of the DBRS acquisition in July 2019. As of December 31, 2019, it had nearly 400 credit rating analysts based in the U.S., Canada, the United Kingdom, India, Germany, and Spain. It also has approximately 1,800 employees who work at data collection, technology, and operational center in Mumbai, India. These employees maintain and update the equity database and PitchBook’s data and research operations, and provide shared services to many of its operations.
License Based – The majority of the research, data, and proprietary platforms are accessed via subscriptions or contract-based licensing arrangements that grant access on either a per user or enterprise-basis for a specified period of time. Licensed-based revenue includes Morningstar Data, Morningstar Direct, Morningstar Advisor Workstation, Morningstar Office, PitchBook Data, Premium Memberships on Morningstar.com, and other similar products.
Asset-Based – It charges basis points and other fees for assets under management or advisement. Morningstar Investment Management, Workplace Solutions, and Morningstar Indexes products all fall under asset-based revenue.
Transaction-Based – Ad sales on Morningstar.com and Credit Ratings products comprise the majority of the products that are transactional, or one-time, in nature, versus the recurring revenue streams represented by licensed and asset-based products.
Morningstar issues a number of different ratings as per this summary table –
|Star Rating||Quantitative rating based on past performance|
|Fund Analyst rating||Forward look, qualitative rating|
|Quantitative Rating||Analogous to fund analyst rating, uses ML statistical model|
|Sustainability Rating||Based on ESG considerations|
The following document shows how the four rating systems work together –
Quantitative research – Morningstar Star Ratings
The Morningstar Star Ratings is the most visible in various publications over the years. The ratings consist of an easily-identifiable five-star scale, designed to assist retail investors with investment decision-making on funds and fund managers.
While a higher star rating reflects stronger performance, a high star rating isn’t a guarantee that a fund will be a solid performer. A fund may very well have a five-star rating because of its impressive historical record, but as performance-chasers often find out the hard way, the past doesn’t reliably predict future returns. This is not to say the star rating doesn’t serve as a valuable tool for investors, but it shouldn’t be the only consideration. Investing in a highly-rated fund is better than investing in the latest ‘hot’ fund, but like any measure, the star rating has both virtues and limitations. It’s important to be aware of these.
The Morningstar star rating for funds is a measure of a fund’s risk-adjusted return relative to similar funds. Funds are rated from one to five stars, with the best performers receiving five stars, and the worst receiving a single star.
Morningstar adjusts for risk by calculating a risk penalty for each fund, based on ‘expected utility’ theory – a commonly-used method of economic analysis. The theory assumes that investors are more concerned about a possible poor outcome than an unexpectedly good one, and are therefore willing to give up a small portion of an investment’s expected return, in exchange for greater certainty.
This concept forms the basis of how Morningstar adjusts for risk. A ‘risk penalty’ is subtracted from each fund’s total return, based on the variation in the fund’s month-to-month return, with an emphasis on downward variation. The greater the variation, the higher the risk penalty. If two funds have the same return, the one with more variation in its return is given the greater risk penalty. Funds are ranked within their categories according to their risk-adjusted returns, after accounting for ongoing fees and expenses. Stars are then assigned as follows:
To determine a fund’s star rating, the fund’s Morningstar Risk score is subtracted from the Morningstar Return score. The resulting number is plotted along a bell curve to determine the fund’s Morningstar Rating. If the fund scores in the top 10% of its category, it receives five stars; if the fund falls in the next 22.5%, it receives four stars; a place in the middle 35.0% receives three stars; those funds in the next 22.5% get two stars; and a fund in the bottom 10% gets one star.
By comparing funds with their closest competitors, investors can focus on the top performers within a given category, without concern over whether the rating is penalizing funds for sticking to an out-of-favor style. All categories, from small-growth to large-value, fall out of market favor from time to time.
What Morningstar star ratings don’t tell you
A measure that takes long-term returns and risks into account is a good first step in a search for ‘best-of-breed’ managed funds. The keywords, though, are the first step. While the star rating is a quick and easy way to get a feel for a fund’s historical performance, it does not capture – nor was it designed to capture – all the factors that will contribute to a fund’s future returns.
The star rating is a strictly quantitative measure – it doesn’t include any input from Morningstar fund analysts about the people who are running the fund, or the investment processes and styles used.
The star rating doesn’t take fundamentals into account – what makes a fund tick.
Qualitative research – Morningstar Fund Analyst Ratings
Introduced formally in November 2011, Morningstar’s qualitative research – analyst research reports – is to determine which fund managers deserve the attention of investors and which do not. Morningstar assesses fund managers on the basis of how they are perceived to perform in the future over an economic cycle, against both peers and accepted benchmarks. The Morningstar model rewards managers which are open and transparent, have a well-run investment process, and most importantly, are good fiduciaries of investors’ monies.
Until 2019, Morningstar qualitative research assesses a fund manager’s capacity in an asset class in five key areas:
- the investment people,
- the investment philosophy and process,
- the composition of the investment portfolio, and how it reflects the process,
- the fund manager’s parent and
- the performance track record.
The portfolio and performance are considered key outcomes of the investment process.
In November 2019, Morningstar consolidated the five pillars into three – People, Process and Parent.
The Morningstar Fund Analyst Rating signals the extent to which the strategy is recommended for inclusion in your portfolio, the standouts in each asset class, the funds which should be avoided, and those in between. The five-point Morningstar Fund Analyst Ratings scale is “Gold”, “Silver”, “Bronze”, “Neutral” or “Negative”.
Fund analysts determine Morningstar Fund Analyst Ratings by considering the process they use, the people running the strategy, and issues relating to the business/parent. A number of characteristics can have positive or negative effects on the overall qualitative assessment, including any portfolio size and capacity issues; the extent to which the investment style used is clearly-differentiated or one of many; the role of the strategy in an investor’s portfolio; the impact of costs including any performance-based fees; and any governance issues or concerns.
Criteria for Fund Analyst Rating
Morningstar Fund Analyst Ratings are decided by considerable and open debate within Morningstar’s fund analyst team. Recommendations are based on the key issues of people, process, and the parent. A number of other issues are also taken into account, including a relative ranking of similar investment styles and approaches.
To determine the Morningstar Fund Analyst Rating, an initial recommendation is put forward by the primary fund analyst. This recommendation is then discussed extensively within the fund analyst team and an overall view is formed. Morningstar Fund Analyst Ratings are discussed with Morningstar’s global fund analyst teams. The Morningstar Fund Analyst Rating is the final outcome of a collaborative process based on a site visit, analyst questionnaire, quantitative and holdings-based analyses of the portfolio, and an assessment of all the key issues outlined.
Morningstar assesses the investment philosophy and process, research drivers, and construction and implementation of the portfolio.
Key questions asked are:
- Is there a clearly-articulated investment philosophy and a process discipline?
- How does the process work in practice?
- How is research performed?
- What are the key drivers, and how is it different to competitors?
- Is the research effort logically consistent with the stated investment process?
Morningstar also considers whether the construction and management of the portfolio reflect the process, and uses holdings-based analysis in order to gain insights into the key portfolio characteristics both current and past.
‘Role in Portfolio’ tells you whether the flagship fund is the core, a supporting player, or satellite holding within the sector under review and whether you need to blend the strategy with other investment styles and strategies. This is a guide only and is not a recommendation to invest.
Morningstar assesses the key individuals making the investment decisions, as well as the composition of the investment team, including:
- Is there a clearly-articulated investment philosophy and a process discipline?
- relative size and resources;
- experience levels and the mix and balance of skills within the overall team skillset;
- the degree of team stability;
- team members’ familiarity with and ability to articulate the promoted investment philosophy and strategies; and
- any key person risks.
In short, how good is the team, and how does it stack up against its peers?
Morningstar does not explicitly rate Performance, which is captured in our Morningstar Rating. Instead, the key drivers of past performance and how they relate to the investment process and philosophy are explored. What has the fund manager got right or wrong, and why? How is the portfolio positioned currently, and why?
Morningstar assesses the fund manager’s parent and/or ownership structure, including organisational and ownership stability. Morningstar focuses on one key parentage issue: is the fund manager likely to be a good steward of investors’ money? The types of products and fees, the investment and corporate culture, back office functions, transparency, and tax awareness are among the key factors considered.
Morningstar qualitative research gives you everything you need to make a comprehensive assessment of whether an asset class strategy deserves a place in your portfolio. You should come away with a clear understanding of the key issues associated with the strategy, and whether or not it suits your needs. We recommend you read the full research report before making any decisions.
|Pillars||Active strategies (weightage)||Passive Strategies (weightage)|
|Price||(factored in by subtracting the price of each vehicle from its expected gross-of-fee alpha)||(factored in by subtracting the price of each vehicle from its expected gross-of-fee alpha)|
Quantitative research – Morningstar Quantitative Ratings
Morningstar’s quantitative rating is created by a machine learning statistical model and analogous to the ‘analyst rating’, Morningstar analyst might assign to the fund covered by them. It is calculated monthly.
Performance of Morningstar quantitative rating since its launch-
Morningstar’s sustainability rating measures the holdings in the portfolio that manage ESG considerations relative to their peers. The Sustainability Rating is depicted by globe icons where High equals 5 globes and Low equals 1 globe. Sustainability Ratings are updated monthly.
Morningstar publishes different types of reports in line with its different ratings mentioned above.
Fund fact sheet
The most ubiquitous is the ‘fund fact sheet’ which includes a plethora of quantitative ratios and charts.
- Performance charts and tables
- Portfolio or holdings-based charts (Style Box) and tables
- Risk and return ratios
References for morning star rating methodology
Overview of Morningstar’s ratings, 2022 – interview with Kaustubh Belapurkar
In this interview with MMI, Kaustubh Belapurkar explains the four rating systems. He reiterates that while its Star Ratings have added value, they are meant to be a first filter and that investors should combine it with qualitative research. The Analyst Ratings look at three aspect – people, process and parent. The Quant Ratings mimic the Analyst Rating using machine learning.
A Look at Our Enhanced Morningstar Analyst Rating, 2019
Discussing major changes in the qualitative rating system, pillars that are taken into consideration are reduced from 5 to only 3, and their weightage differs depending on whether the fund is active or passive. For active funds the rating is based on whether or not the fund beats the index on a risk adjusted basis over a long term, the same is used for strategic beta funds. Passive funds are compared against the category average.
How often do you calculate and publish the performance value-add of your various rating systems?
What has been the value-add of the Analyst Rating system?
Date- 8 jun 2020