Morningstar Inc. on Thursday announced plans to introduce a new global fund rating system based on analysts' convictions about a fund's ability to beat its peer group and/or relative benchmark going forward.

Details about the Morningstar Analyst Rating system were laid out by the company's president of fund research, Don Phillips, and other analysts at Morningstar's investment conference in Chicago. Under the new system, funds will be assigned one of five ratings--AAA, AA, A, Neutral, or Negative.

These ratings, which replace the existing "Analyst Picks and Pans," will be based on analysts evaluation of five criteria, or pillars: process, performance, price, people, and parent. Process and performance evaluate selection of securities and portfolio construction, and how the results have played out over different market conditions. The price component looks at annual expense ratios and other fees. The people category refers to the fund's investment team in terms of experience, stability and alignment of interest with shareholders, while the parent aspect evaluates the fund's parent company regarding how it manages its employees, along with its culture of stewardship.

According to Morningstar, positive ratings of AAA, AA and A indicate an analyst gives a thumbs up to a particular fund and expects it to outperform its peer group and/or relative benchmark on a risk-adjusted basis over a full market cycle of at least five years.

A rating of AAA indicates best-of-breed status, while an AA rating denotes a fund has notable advantages across most, if not all, of the five pillars. An A rating implies that a fund's advantages outweigh its disadvantages across the five pillars to the point where a positive rating is justified. The neutral rating implies a fund will likely be neither a standout nor a stinker, while a negative rating means a fund is likely to underperform in the future.

"It's a framework, not a formula," Phillips said of the new system, which is based on the qualitative, subjective conclusions of fund analysts.

The new rating is designed to supplement the existing star rating system that's strictly a quantitative metric that evaluates funds on historical performance based on risk and cost-adjusted returns.

Morningstar considers its new system to be an aptitude test versus the achievement test of the star rating system.

"We want to keep the star rating completely objective," Phillips said. "We want to leave that as an anchor that investors can use for their research. They know what it means and they know how to interpret it."

Morninstar will roll out its new rating system in the fourth quarter, starting with 150 to 200 U.S. funds that have consistently generated a lot of investor interest, and will boost that coverage to about 1,500 U.S. funds during the next 12 months. In toto, these funds will comprise about 80% of overall U.S. fund industry assets. The new system will ultimately apply to European and Asian funds.

Unlike the former "Picks and Pans" format that highlighted just the top and bottom funds, Phillips said the new system will shed forward-looking perspective on funds in the middle. "There's a lot of money in those funds in the middle, and we think we can add some value there."

Morningstar says it expects less than 5% of all global funds will merit a AAA rating, and just 10% to 20% to be rated A or higher. It expects most funds to garner a neutral rating, and 20% to be designated with a negative rating.

The new rating system will be available for free on the company's website, while fund reports and explanations of the new rating and related data will be available through the site's premium membership.

Financial advisors will be able to access analyst ratings and in-depth global research reports for sale through Morningstar's advisor software products such as the Morningstar Office portfolio management tool.

- Jeff Schlegel