Deciphering Ratings
Everything you need to know about how mutual funds
are rated.
By Ben Mattlin
Just as politicians broadcast favorable soundbites
to win votes, mutual fund companies campaign by advertising positive ratings to the investing public. Look up any mutual fund
in the newspaper or online and chances are, beside recent performance results, you'll see the Lipper letter grade, Morningstar
Star Rating, or Value Line rank. These may seem like seals of approval-and mutual fund companies with high-scoring products
certainly want you to think so-but the truth is, you've got to dig deeper to understand what lies behind and beyond these
symbols, or you could be filling your portfolio with overinflated duds. "You have to be cautious," says Barbara Malone of
Stolper & Company, an investment advisory firm in San Diego. "Ratings can be misleading."
Officially, of course, the three big fund-analysis
companies-Lipper, Morningstar, and Value Line-don't claim to predict winners. They merely use historical data and mathematical
formulas to identify funds with consistently good track records. Based on these calculations, the firms assign grades-letters,
percent rankings, or stars, à la restaurant and movie reviews-that indicate how each fund performs compared with others in
a defined category. The services also provide statistical data and varying degrees of analysis. It's not exactly prognostication,
but it's about as close as you're likely to get.
Not surprisingly, mutual fund companies with five stars
or an A rating treat them like the Good Housekeeping Seal of Approval. But what do such evaluations really mean to
you as an investor? How are they determined? And how predictive are they of future performance?
There are no simple answers to these questions. Each
fund-rating organization has its own formulas, objectives, and methodologies. Often their results are based on different time
periods and return figures. A mutual fund that gets top grades from one company might get so-so marks from another. But one
thing is certain: Understanding how these grading systems work can make you a better fund investor.
Lipper Analytical
This Reuters unit has the most straightforward approach
to rating funds. It collects data on some 8,000 funds and ranks them by raw returns over a designated time frame, typically
3, 5, and 10 years.
If a fund lands in the top 20% of those in its classification,
as determined by Lipper, it receives an A. Those in the second 20% get a B, and so on, down to E, which is equivalent to the
dungeon. That's it.
Lipper's percentile scores are also easy for even novice
investors to grasp: A percentile rank of 53, for instance, means the fund outpaced 53% of other funds in its category. Period.
"We don't rate funds for their overall quality or component characteristics," says Lipper research director Edward Rosenbaum.
"We classify funds and then rank performance within the classifications."
Lipper's classification standards, overhauled last
September, are probably its most important distinguishing feature.
First, stock funds must fit one of the three standard
market-capitalization size designations or be shuffled into a catchall "multi-cap" category, indicating that it holds shares
in small-, mid-, and large-cap companies. The exact market-cap thresholds are calculated monthly by averaging and manipulating
the S&P Mid-Cap 400 and S&P Small-Cap 600 indexes. "We evaluate these indexes as separate portfolios," says Rosenbaum,
"because market-cap definitions can shift a great deal as the overall market advances or declines, and we don't want to send
signals about a change in a fund's characteristics unless it's actually due to an act of style drift."
Second, Lipper divides open-end mutual funds into three
style categories-growth, value, and core-a distinction that attempts to replicate how most investors design their portfolios.
Fund characteristics are determined by a stringent
75% test: At least three-quarters of a fund's assets must fit the category definition, and funds are reevaluated monthly.
It's a tougher standard than Morningstar's. "We don't go by what the prospectus says," Rosenbaum notes. (Nor do Morningstar
or Value Line.) "Our determinations are made by the actual holdings of each fund."
It may sound like nitpicking, but these distinctions
can have significant ratings repercussions. For instance, Lipper pegs the $2.4 billion Vanguard Capital Opportunity Fund as
a multi-cap growth fund; its annualized performance puts it in the top third of the funds in that category over the past three
years. Not bad, but maybe not something you'd rush out to buy. Morningstar, however, dubs the same fund a midcap growth fund,
and as such it beat more than three-quarters of its counterparts-earning it a more positive rating.
Morningstar
Morningstar, with its Five-Star Rating, is probably
the most famous of the fund-rating firms. On the face of it, Morningstar's rating system seems clear-cut. Some 8,000 funds
with at least three years of performance history are compared monthly and awarded between one and five stars, five being the
best. "It's a way of looking at comparative risk and reward for one big asset class," explains Sue Stevens, financial planning
specialist at Morningstar. "We come up with a distribution over a probability curve and slice them up according to who falls
into which portion of the curve over several years."
Each month, the company assesses the funds and sorts
them into one of four categories: domestic stock, international stock, taxable bond, and municipal bond. The top 10% of funds
in each classification get five stars; the others get four, three, two, or one.
The underlying math is somewhat more complicated than
Lipper's. First, Morningstar takes a weighted average of 3-, 5-, and 10-year returns, subtracting loads and other fees. It
compares this adjusted return with that of a 90-day Treasury bill, a sort of low-risk benchmark. The extent to which the fund
outperforms the benchmark is called its "excess return." The company then compares that number with the average excess return
of all funds in its category. A risk score is derived in a similar way: average underperformance relative to a T-bill, divided
by the average for the asset class. This is subtracted from the return score to produce the final grade.
By weighting the numbers, Morningstar aims to emphasize
long-term results, though how well it achieves this goal is debatable. Some investment advisors, such as Barbara Malone of
Stolper & Company, contend that the final rating is overly sensitive to recent performance. "One or two great or terrible
quarters can skew a fund's annualized returns and disproportionately affect its rating," she says. "If you buy the highest-rated
funds, you could be buying them at an all-time high."
It's certainly true that the ratings are largely determined
by past performance, and every savvy investor knows you don't pick your funds by their historical gains. Yet another complaint
is that the four fund categories are too broad to be meaningful. A mutual fund investing in U.S. emerging high-tech companies
is grouped together with an index fund tracking the large-cap, growth-oriented Dow 30. Investors schooled in diversification
and asset-allocation tactics don't think that way; why should Morningstar?
The biggest criticism of Morningstar's system is its
complexity. Even professional analysts have a hard time understanding exactly what a Star Rating signifies. So many factors
contribute to a fund's score that one domestic-stock fund could drop in the ratings simply because all other funds in the
category-the entire U.S. stock market-have been going through the roof. The ratings can also mask potentially significant
events, such as a change in fund management. "If one fund absorbs another-which fund companies do occasionally to erase the
losses of a poor performer-it's never disclosed in the ranking," observes Malone.
To be fair, Morningstar doesn't claim its ratings are
recommendations; in fact, they're not intended to have any predictive power at all. "All along, we've said the Star Ratings
are just a beginning," asserts Stevens. "They help investors who haven't got a clue make some preliminary comparisons. They're
not a shopping list."
That's why some investors pay more attention to Morningstar's
separate Category Rating, which, like the Star Rating, awards mutual funds a score on a 1-to-5 scale, measuring risk-adjusted
returns relative to T-bills. But the Category Rating divides the fund world into smaller groups. For example, stock funds
are broken into small-, mid-, and large-cap, and further subcategorized as growth, value, or a blend of both.
A fund's market cap is calculated as the mean market
cap of the individual stocks in the fund's portfolio. Funds in the top 5% are considered large-cap, the next 15% are midcap,
and the remaining 80% are small-cap. The second measure is determined by generally agreed-upon Wall Street practices that
chart price-to-earnings and price-to-book ratios and compare them with the ratios of other funds in the same size category.
The Category Ratings solve much of the apples-and-oranges
problem inherent in the Star Ratings. Yet they can be perplexing, too. Take, for example, the $535 million Principal Growth
Fund and the $2.4 billion Goldman Sachs Capital Growth Fund. Both get four stars in Morningstar's regular ratings. However,
in the Category Ratings, where they are classified as large-cap, blend stock funds, the Goldman fund earns an impressive 5
while the Principal fund merits a middling 3.
Why? One obvious conclusion is that the competition
is pretty tough in the large-cap blend category, magnifying the impact of relatively small performance differences. But there
are probably other factors at work, too. For example, Goldman Capital Growth has a higher load, and the Category Rating doesn't
subtract loads the way the Star Rating does. Also, the Category Rating covers only the most recent three years, and the shorter
time frame would favor Goldman, which scored 5 stars in the three-year Star Rating but only 4 in its five-year counterpart;
Principal Growth, on the other hand, received a lowly 3 stars in both the three-year and five-year ratings, though it scored
4 stars in the 10-year version. Which figures do you trust?
Value Line
A publisher of stock ratings and analyses since 1931,
Value Line also puts out the The Value Line Mutual Fund Survey, which measures performance in three categories: equity
and partial equity, taxable bonds, and municipal bonds. Funds are rated on a 1-to-5 scale based on three-year risk-adjusted
performance. Value Line factors in risk, dividing annualized three-year returns by the standard deviation. Arguably more useful
is Value Line's one- and five-year "growth persistence" rating, which measures not how much a mutual fund outstripped its
group but how often, rewarding consistency rather than magnitude.
Unlike Lipper and Morningstar ratings, the Value Line
scores aren't published in newspapers; you have to subscribe to the Survey, which is published every two weeks on paper for
$295 a year (available in most public libraries), and every month on CD-ROM for $395 a year. The CD-ROM version is much more
comprehensive, providing performance figures on the entire database of 10,000-plus funds. The printed reports cover some 150
funds. Funds are reevaluated three times a year.
In addition to statistics and rankings, the Survey
offers comments from Value Line's squad of 30 analysts-a review of recent market developments, subjective appraisals of fund
managers' strategies, and advice for investors with different goals and asset-allocation needs.
Advertising
In their quest to attract investors, mutual fund companies
will no doubt quote whichever ranking sounds more favorable. The category determination made by each of the three fund-rating
firms leaves ample room for mutual fund advertisers to feature their funds in the best light. Often the ratings highlight
hot fund categories. For example, the average fund in Morningstar's technology category rates 5 stars for the last three-year
period.
The three rating organizations may base their assessments
upon different performance during different time frames and with varying return figures. For example, one rating may may be
calculated by subtracting the load, while another may not. The variables that go into each organization's formulas are not
consistent across the three rating systems. Category classification standards, market-cap designations, time period, return
adjustment, frequency of evaluation, and weighting all figure into the variability of fund ratings. When evaluating a mutual
fund, the wise investor will examine the system that generates the rating featured in the advertising.
All of these mutual fund rating services can be useful
when choosing a fund. Star and numerical ratings are good ways to spot promising investment candidates quickly and weed out
the real dogs. The key is not to stop there. No single grade, no matter how fancy the calculations behind it, can give you
a complete picture of a fund's past performance, much less predict how it will do next year.
Nor can it tell you whether it's the right fund for
you. Investment success comes from closely matching your investment goals with those of the funds in your portfolio. That
means, at the very least, understanding the fund's objectives, as spelled out in its prospectus, and taking a hard look at
the numbers behind the box scores. After all, the best portfolios reflect an asset-allocation strategy that suits individual
investment goals and risk tolerance. Simply filling a portfolio with only grade-A or five-star funds would be like voting
for President based on soundbites.
--Ben Mattlin is a freelance business writer based in southern California.
ON INVESTING
is provided to you compliments of Charles Schwab & Co., Inc. It is prepared by Bloomberg L.P., an independent news and
research company which is not affiliated with Schwab.
