Morningstar Magazine - February/March 2018 - 47

Analyzing the Analyst Rating
On balance, the rating succeeds in
predicting funds' future performance.

INVESTMENT RESEARCH: MUTUAL FUNDS

Jeffrey Ptak

The Morningstar Analyst Rating has succeeded in
predicting funds' future risk-adjusted returns,
with higher-rated funds generally outperforming
lower-rated funds, according to a recent
Morningstar study. That said, the study also
identified areas where there's opportunity
to improve the way that analysts assign ratings.
Launched globally in November 2011, the Analyst
Rating is a forward-looking assessment of a fund's
ability to outperform its peer group or a relevant
benchmark over a market cycle, after accounting
for risk and expenses. The Analyst Rating takes the
form of Gold, Silver, Bronze, Neutral, or Negative,
with Morningstar Medalist ratings reserved
for funds the analysts have higher conviction in.
To study the Analyst Rating's performance, we
analyzed the returns of more than 4,500 unique
open-end funds globally that were assigned
Analyst Ratings between November 2011 and April
2017, including dead funds. (We tracked
subsequent returns of rated funds through Oct.
31.) We evaluated rated funds' performance using
two techniques: a cross-sectional regression
and an "event-study" framework.

We employed this technique to compute the
average monthly return premium for investing in
funds rated Gold, Silver, Bronze, and Negative
versus investing in funds rated Neutral. Put
another way, the premium for a given rating can
be interpreted as the average return of that
rating above or below a Neutral-rated fund after
controlling for other variables, including risk
factors and expense differences. We label those
average monthly premiums the "mean" in
E X H I BIT 1 . We also display the standard error (the
standard deviation of the parameter) and t-statistic.
In equities, medalist funds achieved higher
risk-adjusted returns than Neutral-rated funds, as
evidenced by the positive means shown for
Gold, Silver, and Bronze. On the flip side, Negativerated funds underperformed Neutral-rated funds.
What's more, all but one of these premiums
were statistically significant. (Silver-rated funds
outperformed but at a lower t-statistic.) The

We also examined how these premiums would
have compounded over time. We charted
the growth of $1 by compounding the monthly
premium series for each rating tier per asset class.
( EXHIB IT 2 shows the growth of $1 for rated
equity funds. ) After controlling for common factors,
we found these premiums compounded to
meaningful differences in the benefits investors
would have reaped from hypothetically
investing in medalist funds versus Neutralor Negative-rated funds.
Event-Study Framework

The event-study framework is a simpler, easier-tounderstand approach. At a given month-end,
we grouped funds globally by their Analyst Rating

EXHIBIT 1

Medalist Premium As evidenced by their positive mean scores, funds rated Gold,
Silver, or Bronze achieved higher risk-adjusted returns than Neutral-rated funds.
Fama-MacBeth Regression Statistics
Asset Class

Statistic

Œ

„

´

‰

Mean

0.10

0.06

0.05

-0.21

Standard Error

0.04

0.04

0.03

0.09

T-Statistic

2.22

1.67

1.83

-2.39

Mean

0.08

0.09

0.04

-0.01

Standard Error

0.04

0.03

0.03

0.02

T-Statistic

2.23

2.69

1.42

-0.55

Equity

Cross-Sectional Regression

The Fama-MacBeth cross-sectional regression
is used to estimate parameters for pricing
models, such as the capital asset pricing model.
It is a two-step process: 1) run a time-series
regression to determine an asset's risk factor
exposures, and 2) run a cross-sectional regression
across assets to determine the risk premium
for each factor.

findings were similar, if less conclusive, among
rated allocation and fixed-income funds. Here,
medalist funds generated superior risk-adjusted
returns compared with Neutral-rated funds,
and Negative-rated funds underperformed.
However, the premiums for Bronze- and Negativerated allocation funds and all but Silver-rated
fixed-income funds were not statistically
significant. Moreover, Gold-rated fixed-income
funds didn't sort monotonically like the other asset
classes, as the premium for that cohort was
less than those of Silver- and Bronze-rated bond
funds. All the same, directionally, the Analyst
Rating exhibits the ability to successfully sort
funds in these areas.

Allocation

Fixed Income

Mean

0.02

0.06

0.04

-0.01

Standard Error

0.04

0.03

0.02

0.02

T-Statistic

0.60

1.84

1.75

-0.38

Source: Morningstar. Data as of 10/31/2017.

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