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Morningstar's revamp aids investors

In the United States, where more funds are bought directly rather than through advisers, one of the most popular selection criteria has been to rely on the star rating system offered by Morningstar Inc. In fact, several studies have shown that funds rated with four or five stars by Morningstar regularly receive a disproportionate chunk of new investor dollars.

Recently, the Chicago-based research firm announced significant changes to its rankings that may make it easier for investors to uncover the right fund for their needs. From now on, five stars will mark a fund as being at the top of its category rather than just a good overall performer -- a long overdue development.

Of course, while clearly the dominant brand globally, Morningstar (http://www.morningstar.ca) is not the only purveyor of star ratings in Canada. Both Globefund (http://www.globefund.com) and FundScope (http://www.fundscope.com) offer a ranking service. As well, Fundlibrary.com (http://www.fundlibrary.com) provides a composite rating that draws from these and other providers, including fund analysis firm Fundata Canada Inc., and author Gordon Pape.

In its early days, Morningstar ranked funds from one to five stars in one of four extremely broad asset classes: U.S. stock funds, international stock funds, taxable bond funds and municipal bond funds. The performance data were adjusted to take into account the risk and costs associated with the fund.

In many instances, the rating system's popularity hindered the process of choosing a fund as much as it helped, since it couldn't take into account the wide variations in performance that occur among the various styles of investing. Under the old methodology, a fund investing in large-capitalization growth stocks was ranked not only against other, similar funds, but also against funds investing in smaller, value stocks or even funds concentrated in, say, financial services stocks.

Not only did this make the star rating a weak judge of manager talent, but it also made it difficult for investors to use it as a primary screen. In recent years, funds have become more style-specific, focusing on buying stocks in well-defined categories and more closely mirroring the practices of large, institutional investors.

Under its original star-rating system, greater specialization meant that a fund's chosen investment universe would frequently overwhelm a manager's skill and overemphasize sector momentum.

A few years ago, most high-yield bond funds were awarded four or five stars because high-yield bonds were producing higher returns than the rest of the bond universe. Likewise, large-cap growth funds nearly all sported four or five stars at the end of 1999, while only a couple of small-value funds had five stars. Today, a value rally has moved small-value funds nearer the top of the heap, but managers in this sector clearly didn't get that much smarter over the past 18 months.

Acknowledging this, Morningstar offered its category rankings as an alternative, whereby it ranked a fund within its own peer group, such as U.S. large-cap growth or European stock. U.S. stocks, for instance, are divided into 18 categories based on investing style and industry sector. However, these distinctions will now be less important under the revamped system.

With its new methodology, 10 per cent of, say, small-value portfolios will always get five stars and 10 per cent of the group will always get one star -- regardless of whether small-value stocks as a whole have just enjoyed a big rally or suffered a major selloff.

Too often, investors pick good funds but use them poorly. They buy after a hot streak and sell when things go bad -- in effect, buying high and selling low. By trying to prevent its star ratings from being skewed toward some categories and away from others, Morningstar's revamp should help investors avoid this dilemma, allowing them to concentrate instead on diversification and portfolio construction.
Gordon Powers heads up Affinity Group, an Ottawa-based financial services consulting firm.
gordpowers@aol.com

© 2007 The Globe and Mail. All rights reserved.

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