Digging Into Morningstar's Medalist Ratings Shift: Roth

Recently, Morningstar made some methodology changes in its forward-looking medalist fund ratings for ETFs and mutual funds. The Morningstar Medalist Ratings provide investors with assessments of a strategy’s ability to outperform its Morningstar category index after fees. I spoke to Jeffrey Ptak, Morningstar’s chief rating officer, about these changes and here’s what I learned followed by my assessment.

As a reminder, Morningstar awards ratings of gold, silver, bronze, neutral, and negative, in respective order of how the firm expects each fund to perform relative to others in the same category. Ptak told me that while the results of the medalist performance under the old methodology have been encouraging, he believes the new methodology will be even more predictive. 

Methodology Change

The key change in methodology is in the evaluation of pre-fee potential performance. The old methodology would look at rolling 36-month past risk-adjusted performance of all funds in each category and then take the average of each fund’s 75th and 25th percentile performance in each category. The new methodology essentially takes the percentage of positive alphas times the median positive alpha. This methodology is for active funds which includes strategic Beta (aka Smart Beta) funds since they try to outperform the market.

The above is an oversimplification of the new methodology which went into effect on Oct. 29, though funds covered by Morningstar analysts will be updated gradually over the next year as analysts regularly update their coverage. Index funds will also see a methodology change to a more rules-based methodology using 13 different sets of data.

Impact of Changes

Ptak told me to expect about 18% of fund ratings to change. Most of the changes will be downgrades from the old methodology as shown below.  

 
(Source: Morningstar, as of July 31, 2024; includes all rated vehicles globally)

An example of how to read this chart for past bronze rated funds under the old methodology is that 41% of those funds will get a downgrade, 3% will get an upgrade, and 56% will remain unchanged. The new methodology downgrades more heavily impacted active funds than index funds. For active funds, 23% saw downgrades while only 2% upgrades. Only 4% of index funds had downgrades while 4% also saw upgrades.  

The overall distributions under the old and new methodologies are expected to look as follows. 

I was actually surprised by the skewness toward neutral and negative as I typically see new clients coming in with medalist funds rather than neutral or negative. In hindsight, that made perfect sense in that funds with the most assets have performed well and get higher Morningstar ratings. Ptak produced the following chart for this article.  

Gold funds have an average of $12.45 billion in assets while negative-rated funds average only about $750 million. Using a five-point scale where 5 is gold and 1 is negative, Ptak calculated that the simple average rating was 2.2 (just above neutral) but the asset weighted average was 3.8 (just below silver). And, not surprisingly, gold-rated funds had an average annual expense ratio of 0.57% while negative-rated funds were nearly three times higher at 1.69%. 

My Take

First of all, I want to acknowledge my appreciation of Jeff Ptak, who spent an enormous amount of time to explain the new methodology to me and running data for me. While I do have some concerns that the new methodology doesn’t take into account the magnitudes of the underperformance of the left tail (extreme underperformance), I don’t have a better methodology to propose. Methodologies I came up with placed too much reliance on past performance, which we all know is not a good predictor of future performance.  

Ptak agreed with me that alpha in each market overall is zero before costs and negative after costs. Mutual funds and ETFs are part of total markets so they could overall have some positive or negative alpha before costs. But the higher the fees, the lower the likelihood of besting the index or the fund’s category average.  

Thus, the fact that the new methodology produces lower pre-fee alpha potential than the old methodology makes sense to me. That same logic also supports why the downgrades are more heavily weighted for active than index funds. So my conclusion is that I think the new methodology will be even more predictive of future performance for each category than the prior methodology.

So, much like the refresh of Morningstar’s iconic style box, the Morningstar medalist rating methodology enhancements are an improvement as well. It will do even more to help investors and advisors select funds more likely to have better investor outcomes.