Morningstar to Change Ratings System
Mutual fund rating firm Morningstar Inc. said Monday that it will overhaul its “style box” rating methodology, which will change how the company classifies some stock mutual funds.
By midyear, the Chicago-based firm will sharply expand the criteria it applies to fund portfolio holdings to gauge where a fund fits in the rating system’s style box grid.
The goal is to do a better job of accurately capturing fund managers’ investing strategies, said Don Phillips, Morningstar’s managing director. He created the style box grid in 1992 as a tool to help investors and financial advisors build diversified portfolios of funds without relying solely on how fund companies label or describe their portfolios.
On the nine-square Morningstar grid, well-known to many mutual fund investors, the vertical axis distinguishes among funds that own small-, mid- and large-capitalization stocks, while the horizontal axis classifies funds as either growth-oriented, value-oriented or a blend of the two disciplines.
Every rated fund still will fall into one of the nine squares on the grid. But a fund’s square could change depending on how its stock holdings, overall, are classified under Morningstar’s new criteria.
Currently, after sorting by size, Morningstar categorizes stocks based solely on two yardsticks: price-to-earnings ratio and price-to-book-value ratio (a measure of a company’s assets).
Under the new system, stocks will be evaluated based on those ratios and eight other yardsticks: price-to-sales, price-to-cash-flow, dividend yield, long-term projected earnings growth, historical earnings growth, sales growth, cash-flow growth and book value growth.
With the new criteria, Morningstar’s system for the first time will incorporate estimates of future performance, as opposed to simply looking at stocks relative to recent earnings and asset values.
Stocks will be labeled value, growth or “core” (i.e., a blend of value and growth) based on their aggregate score across the 10 criteria.
Because individual stocks will be labeled differently under the new Morningstar system, so too will some funds, depending on what’s in their portfolios.
For example, the Janus, Janus 20 and Janus Olympus funds now are categorized as large-cap blend. But the new system will shift them to large-cap growth, Morningstar said, because the additional yardsticks used to evaluate their holdings indicate a tilt toward growth.
Similarly, “while the stocks in Putnam Small Value occasionally look pricey using trailing price-to-earnings ratios, the fund’s value-oriented strategy of buying battered growth stocks becomes more apparent when the categorization criteria widens to include price-to-sales and price-to-cash flow,” Morningstar said.
Hence, the firm expects to reclassify Putnam Small Value as a small-cap value fund. It’s now designated small-cap blend.
The ratings-system overhaul doesn’t address one shortcoming beyond Morningstar’s control, however: Fund companies are required to report their portfolio holdings just twice a year. So Morningstar’s style-box classifications can become dated if a fund’s holdings change significantly in a short period.
