Morningstar Analysts’ New Focus on Fund Fees Underwhelms Some Advisors
Morningstar’s decision to emphasize expenses in determining the ratings of mutual funds will make investors more skeptical of active management and was long overdue, according to some advisors and other analysts.The fund rating firm that sells its services to some 255,000 financial advisors said Monday that as of the end of October its analysts will begin “doubling down” on fees as a determinant of the forward-looking gold, silver, bronze, neutral and negative ratings they attach to funds. (Morningstar is not making changes in the popular star ratings it applies to its backward-looking calculation of fund performance.)
“Over the long run, fees will catch up with even the best mutual fund managers,” said Sam G. Huszczo, founder of SGH Wealth Management, a Southfield, Michigan, wealth management firm.
Given the vast array of investment vehicles widely available to advisors, he said he was surprised that it took this long for Morningstar to acknowledge the importance of fees to investors’ returns.
Morningstar has always emphasized fees in its analyst and algorithmic-determined quantitative ratings, Jeffrey Ptak, Morningstar’s global head of manager research, said in announcing the changes. But he acknowledged that the new methodology will put much greater weight on fees, setting “a higher bar” for active funds with bigger expense ratios than passively managed index funds.
“We’ve been selective when recommending active funds in the past, but we’ll be even pickier in the future, as we’ll be applying an even more exacting standard,” Ptak wrote. “[E]xpect ratings changes to occur, with downgrades likely to outnumber upgrades.”
For broker-dealers who receive 12b-1 and other so-called distribution fees from fund companies and who sell internally managed funds, the ratings change also is likely to be an unwelcome alert signal to investors.
For the first time since launching its rating service of future performance in 2011, Morningstar analysts will begin evaluating each share class of a fund, meaning that “A” shares and “C” shares will be prone to receive lower ratings than so-called institutional-class shares, Morningstar said.
The Chicago firm’s analysts currently uses a single share class to apply across all of a fund classes.
Brokerage firms have already been cracking down on the magnitude of fees that are paid to brokers rather than invested in funds. Morgan Stanley, which stopped selling low-expense-ratio Vanguard funds two years ago, this year began requiring its advisors to convert C-class shares that generally pay them 1% of a customers’ fund holdings to lower-paying A-class shares after six years.
A Morgan Stanley spokeswoman said the firm declined to comment on the new Morningstar ratings methodology.
Under the new system, Morningstar analysts evaluating active management strategies will award the firm’s top three ratings (gold, silver and bronze) only to funds that both beat their category benchmarks as well as their peer group averages. In the past, analysts used one of the two comparative benchmarks to create a performance rating.
Expensive but truly top-performing funds can still get a strong rating, Morningstar said.
To ensure such funds are not punished solely because of cost, analysts will calculate the estimated value of performance to investors before fees in arriving at a recommendation. Currently, they compare expense ratios against other funds in the same style category, factoring it as one element of their overall rating. “What will matter is whether fees are low enough to leave some value for investors,” Ptak wrote in explaining the changes.
Registered investment advisors have been increasingly using the fee-influenced analysis that Morningstar plans to adopt, said Todd Rosenbluth, senior director of ETF and mutual fund research at independent research firm CFRA.
“This is a logical move by Morningstar,” he said. “It reflects industry trends where advisors are increasingly using fees as a decision-making tool and is a recognition that passive investments are gaining ground.”
Morningstar expects to issue its initial batch of updated analyst ratings for hundreds of funds on Oct. 31, 2019, and complete the process for its covered universe within the following 12 months. Its Quantitative Ratings that are not calculated by human analysts will be updated en masse in November 2019, Ptak said.