Morningstar’s multifaceted rating system for mutual funds is often a go-to reference for financial advisors and individual investors, and the Chicago-based fund research company last month announced it is altering its methodology by streamlining its analyst ratings system and putting more emphasis on fees. It also sets a higher bar for actively managed funds, but the changes won’t have any impact on its star-rating system that many investors rely on (perhaps too much) when selecting funds.

The company says the enhancements are designed to make its forward-looking analyst ratings more relevant and easier to use. Morningstar said at the time of the announcement that the updated rating system was 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.

The enhancements pertain to various “pillars” that analysts use to rate funds. For example, 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. Under the prior system now being phased out, Morningstar ranked a fund’s fees against those in its peer group. Under the new system, fund costs are compared to the estimate of what value it can deliver before fees.

“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.

In addition, the three-point rating system of Positive, Neutral and Negative has been replaced and expanded to 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.

These enhancements to the analyst ratings have already had an impact on the first batch of funds scrutinized under the new system. For example, downgrades outnumbered upgrades by a 2-to-1 ratio. 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.

Anything to help make fund performance more predictive is a good thing, but many investors still look in the rearview mirror when they make investment decisions. And that’s where Morningstar’s star-rating system comes into play. In an interview, Ptak said Morningstar assigns stars to funds by comparing their trailing risk-adjusted returns versus those of category peers over the trailing three-, five- and 10-year periods. If the latter two periods aren’t available, it’s just the three-year period. It essentially follows a bell curve where the 10% of funds with the best risk-adjusted returns in their categories in the trailing periods receive five stars. The next 22.5% get four stars; the middle 35% get three stars; the next 22.5% get two stars; and the bottom 10% get one star.

“It’s quantitative and backward looking, which is why we typically characterize it as a starting point to search for funds, not something designed to be predictive,” Ptak said.

He recognizes the star rating has a strong following. So strong, in fact, that some observers believe it causes investors to chase returns when they select mutual funds.

“Data suggests there’s a correlation between flows in star ratings,” Ptak said. “The other thing I’d observe is there’s a correlation between star rating and other attributes we think are important, such as low expenses. The best-performing funds tend to have lower expenses. That’s why we tend to find that higher-rated funds are cheaper than lower-rated funds.

“We have other rating systems we think are useful companions to the star-rating system, including the analyst rating,” he continued. “The analyst rating is forward looking and qualitative as it turns on our analysts’ assessments of a fund’s investment merits. We think it’s a powerful combination when you marry the two.”