To Rate or Just to Rank?
Morningstar, Value Line Defend Their Services
Few things have caught on in the investment world more quickly than Morningstar's star-spangled rating system for mutual funds. Hollywood's movie-rating system just may be a little more famous.
Chicago-based Morningstar was founded in 1984. Soon, mutual funds that won five-star ratings touted the fact in advertisements.
But is this famous rating service - and newer rival, The Value Line Mutual Fund Survey - overrated?
Investment professionals say misunderstood is a better word.
Many experts prefer to simply rank funds against their peers according to how well they perform over a given period of time: a quarter, year, or several years.
And even the rating services sound modest in their claims.
"The star system is not a buy signal," says Morningstar spokesman Michael Van Dam. "A fund might get a five-star rating because it's a high-flying tech fund, or it might get the same rating because its manager has done well over a long period."
And, although thousands of investors use these publications to help them decide where to put their money, he adds that "the star-system is not even meant to be a way to pick funds."
Puzzling? Perhaps not when you dig into what a rating means.
First, Morningstar and Value Line certainly hope their ratings will be useful to fund-pickers, though not by any means a substitute for other research.
For Morningstar, a rating is an assigned value judgment of how well a fund might do, relative to its riskiness, based on historic performance. Performance in financial markets is never predictable, but rating is an effort to come as close as possible. How the rating services arrive at their judgments is subjective and proprietary.
Both Value Line and Morningstar follow similar formats: a one-page analysis of each fund (a format made popular by Value Line years ago in its ratings of individual stocks).
On a Value Line fund page, the upper left corner shows the fund's five-year return (performance), a subjective risk rating (1 safest, 5 most volatile), and an overall rating (again on a 1-to-5 scale).
Morningstar's rating system goes in the reverse order, with five stars being best and one worst. (On Page B1, you can see Morningstar's overall rating for the 20 largest stock funds.)
Both rating services provide a wealth of other information, from a few paragraphs of commentary to lists of the fund's largest holdings (individual stocks or bonds). Morningstar's biweekly publication costs $425 a year; Value Line's is $295. Many public libraries carry one or the other.
How the ratings are done
To assign its ratings, Morningstar first breaks funds into four categories - equity, hybrid, taxable fixed income, and tax-free fixed income. For each of the four groups, Morningstar does a bell curve. Funds in top 10 percent of a group get five stars, the next 22.5 percent get four, the next 35 percent of the curve get three, the next 22.5 percent get two, the last 10 percent get one star.
Even Morningstar officials say that the proprietary rating system is subject to constant improvement.
There's a lively debate in the fund-analysis industry over the value of rating funds. Number-cruncher Lipper Analytical Services Inc. of Summit, N.J., which provides data to newspapers and financial planners, and others, does not rate funds.
"We haven't seen any risk schemes that work," sniffs Lipper spokesman John Teall. He continues in a cool politeness: "We're not willing to pour our opinion into a muddled stew."
"We watch the insults go back and forth between Lipper and Morningstar," chuckles Dawn Kahler, spokeswoman for CDA/Wiesenberger, another mutual-fund analysis firm, in Rockville, Md., which serves investment professionals.
"Oh we're not aware of insults!" says Morningstar's Mr. Van Dam - speaking pleasantly and most certainly with a smile.
"But we do insist on giving the public all of the information," he adds, in an indirect reference to Lipper, which serves almost exclusively institutional clients.