Morningstar’s rating system for mutual funds is often a go-to reference for financial advisors and individual investors, and the Chicago-based fund research company today announced it has altered its methodology by streamlining its rating system and putting more emphasis on fees.

The company says its enhancements are designed to make its forward-looking ratings more relevant and easier to use for investors. Morningstar’s updated rating system is now in use for 123 funds spanning 556 different share classes, and the rest of its coverage universe will be updated during the next 11 months or so.

Among the highlights:

• Morningstar will continue to rate funds on a Gold, Silver, Bronze, Neutral and Negative scale, but it’s streamlining its five-pillar framework to three pillars: People, Process and Parent. The Performance pillar is getting shifted into People and Process as a way to link performance to a broader assessment of a fund’s strategy and the people behind it. And the Price pillar is no longer part of the equation. In the prior system now being phased out, Morningstar ranked a fund’s fees against those in its peer group. In the new system, fund costs are compared to the estimate of what value a fund can deliver before fees. In addition, Morningstar will no longer assign the same rating to all of a fund's share classes no matter what fees they charge. Instead, each of a fund's share class offerings will be rated by taking their specific fees into account.  

“We’ve moved to simply subtracting a fund’s expenses from our estimate of how much value it can add before fees,” according to an article on the new rating system written by Jeff Ptak, Morningstar’s global director of manager research. “If there’s nothing left for investors, then we won’t recommend the fund. This approach amplifies our fee assessment, making it as important as People, Process, and Parent combined.”

• The enhanced rating system makes it harder for active funds to earn a Gold, Silver or Bronze rating. Under the new system, Morningstar analysts won’t recommend an active fund unless they conclude it can beat both its benchmark index and its peer group average after fees, adjusted for risk. In the past, analysts might recommend an active fund if it could beat its peer group but not a costless index.

• The three-point rating system of Positive, Neutral and Negative has been replaced and expanded by a five-point scale comprising High, Above Average, Average, Below Average and Low. Morningstar believes this will make it easier to compare ratings between funds. “We’ve also taken steps to better quantify the expectations we form for how much value a fund can add (or subtract) before and after fees, and to further systematize how we translate those estimates into an Analyst Rating,” Ptak wrote.

Tougher Standards

Among the first wave of 123 funds and their share classes rated under the new methodology, downgrades outnumbered upgrades by a 2-to-1 ratio. About 85% of the ratings changes were one-rung, and Bronze-to-Neutral and Silver-to-Bronze were the most common moves.

And fund share classes with Above Average and High fee levels saw downgrades at roughly four times the rate of inexpensive share classes rated Below Average and Low. According to Morningstar, nearly every ratings change resulted from accounting for their specific fees.

All told, roughly 63% of share classes rated under the updated methodology kept the same rating while 37% saw a change.

As such, Morningstar says, investors should still have confidence in relying on the old rating system during the interim period as it shifts all funds in its coverage universe to the new methodology.

Morningstar says its new system aims to make its ratings more predictive. With active funds, that means more precisely quantifying the potential value they can add before and after fees. The company also says it should help make it easier for investors to understand what’s driving the rating on a particular fund.