'New' Morningstar Tricky to Evaluate

Charles A. Jaffe is mutual funds columnist at the Boston Globe

In the movie "The Jerk," comedian Steve Martin runs through town crowing about the arrival of the new telephone book.

In a sad commentary on the life of a mutual funds columnist, I've recently been in the same mode, saying over and over: "The new Morningstar is here! The new Morningstar is here!"

The "new Morningstar" is the revised Morningstar Mutual Funds, preeminent source of fund analysis for average investors and bestower of the stars, the rating system so crucial to popular decision-making that about 95% of new investments go to funds with Morningstar ratings of four or five stars.

The question is whether you should care. It's not a simple question.

Morningstar has made two key changes to its evaluations.

First, the Chicago firm changed the categories by which it classifies funds. Funds used to be categorized as a mix of style and the size of the issues purchased, so that a fund looking for big but undervalued companies was a "large-cap value fund."

But many funds defy classification, mixing holdings or promising to invest in one thing but putting their money into another.

Morningstar's new system simply labels funds small, medium or large, and categorizes the style as growth, value or blend. The company assigns a fund to a category

based on portfolio characteristics over the last three years.

The result makes it easier to compare funds, as long as you keep in mind that the categories are based on the history of the fund.

But there are also 44 categories, when you figure in specialized, sector and bond funds and the like.

"We don't mean to suggest that people need 44 funds," says John Rekenthaler, Morningstar's publisher. "By no means are we endorsing that you should own specialty precious metals funds, for example. We need to help people analyze those funds if they decide to own one, but you can make a perfectly good portfolio and never own funds in more than four or five categories."

Which brings us to Morningstar's second big innovation, "category ratings." Essentially, this is a measure of how a fund did among its more tightly defined new peer group.

This is important because of the value investors place on the star system. Ratings are a risk/reward measure, determining whether a fund delivers returns consistent with the risks it takes. Some investment categories are so volatile that funds in those issues seldom get high star ratings. The best gold funds, for example, almost never earn more than three stars.

The category rating--a little speedometer-like graphic rising from worst to best--says that a fund is, perhaps, the best of a bad lot. The investor who wants to diversify into an out-of-favor category learns which funds have the three-year risk/reward characteristics that Morningstar prefers.

But if category ratings make a case for buying a fund that beats its peers, they may also spur sell-offs. Consider three large-value funds: Vanguard Windsor, Windsor II and Oppenheimer Quest Value A. All earn four stars and offer above-average historical returns with average-or-below levels of risk. Yet the Oppenheimer fund has the best category rating, Windsor II beats only its average peers and Windsor gets a run-of-the-mill grade.

"That is not meant to be a sell signal," says Amy Arnott, editor of Morningstar Mutual Funds, "but if your fund has a low category rating, or lower than you expected, you should check into it and find the reason for that drop-off in performance."

The problem is that Morningstar's own analysis of the funds doesn't answer that question, meaning that most investors will have to divine the answer. (Yes, Windsor has a new manager, but there is no indication that his one-year tenure is responsible for the "average" three-year category rating.)

That could lead to over-managing a portfolio, which can be worse than holding "average" funds.

Given the likelihood that funds will advertise their category rating, this could work like the star system, whereby people feel compelled to buy highly rated funds without even a vague understanding of how the rating system works.

So, on the one hand, Morningstar has provided more valuable data. On the other, it has added to the data overload that already paralyzes so many people. The result is that the new Morningstar will only help those investors who use it properly.

Clearly, the stakes for fund investors have been going up for years, and this raises them further. To "get with the program and do research the right way," as Rekenthaler noted, "you need to know more than you did two years ago."

But it also doesn't have to be so complicated. There are thousands of decent funds. And, just as important, there is nothing wrong with letting your money ride in funds that don't upset your stomach.


Charles A. Jaffe is mutual funds columnist at the Boston Globe. He can be reached by e-mail at jaffe@globe.com or at the Boston Globe, Box 2378, Boston, MA 02107-2378.

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