Morningstar, Inc. yesterday launched a series of products that will do for hedge funds what it has long done for mutual funds. The Chicago-based investment research firm introduced a rating system for hedge funds, along with new hedge fund indexes, to help investors gauge this increasingly popular investment class.
As with mutual funds, Morningstar's hedge fund rating system employs a scale of one to five stars. And to make sense of the hedge fund universe, Morningstar places them into 17 categories-ranging from convertible arbitrage to emerging market equity-based on various quantitative and qualitative measures. From there, it ranks and rates the hedge funds against their peers in their respective categories based on risk-adjusted returns.
Morningstar's methodologies seek to address two issues peculiar to hedge funds. First, unlike other risk-adjusted performance measures such as the Sharpe ratio, Morningstar doesn't assume that hedge fund returns follow the normal bell curve distribution. Second, in order to circumvent hedge fund managers' flexibility in how they value infrequently-priced illiquid securities, Morningstar applies a statistical procedure to the return series and then calculates the risk-adjusted return measure. This measure accounts for all variations in a fund's monthly performance, with more emphasis on downward variations.
Morningstar's database contains about 4,400 direct hedge funds and 3,300 funds of hedge funds. Direct hedge funds must have at least 38 months of consecutive performance data to be rated, and Morningstar expects roughly 1,800 of them will receive ratings. Funds of hedge funds aren't eligible to receive ratings.
Morningstar also launched the Morningstar 1000 Hedge Fund Index, a global, broadly representative benchmark for hedge fund performance. The index is composed of the top 90% of eligible assets in Morningstar's hedge fund database. For the purposes of the index, Morningstar counts funds with shared portfolios as a single hedge fund; funds of hedge funds are excluded from consideration. The index is updated daily for the previous month-end, rebalanced monthly, and reconstituted semi-annually.
Hedge fund star ratings and indexes are now available to Morningstar Licensed Data clients; in Morningstar Direct, its Web-based institutional research platform; and in Morningstar Advisor Workstation Office Edition, its Web-based investment planning system for independent financial advisors. Ratings are also available to accredited investors who are premium members of Morningstar.com, Morningstar's Web site for individual investors. Hedge fund indexes will also be available in EnCorr, Morningstar's asset allocation software.
For more information about the Morningstar Rating for hedge funds, category classifications, and the Morningstar Hedge Fund Indexes, please visit http://global.morningstar.com/hedgefundratings.