Morningstar Magazine - February/March 2018 - 50

Strategies

EXHIBIT 4

Rating the Rating, U.S. Edition Against category averages and indexes, performance
of the Analyst Rating was generally mixed. It improved when we used CAPM alpha.

In that spirit, it behooves us to reflect on where
the opportunities are to improve.

Cumulative Excess Returns vs. Category Average

First, improve our risk-unadjusted performance.
For example, the average Silver- and Bronze-rated
fund suffered negative excess returns versus
the category index. We also need to better
identify underperforming funds in advance, as the
average Neutral- and Negative-rated funds
achieved positive excess returns compared with
the category average. The Analyst Rating's
performance strengthened once we accounted for
risk, but we realize that some investors will define
success as outperforming an index before risk.

Asset Class

Months From Rating

Equity

Allocation

Œ

„

´

‰

Á

12

1.08

0.09

0.25

0.38

0.05

36

2.29

-0.14

0.18

0.88

1.22

60

4.75

-0.10

1.22

2.32

1.67

12

1.47

0.98

0.67

0.28

0.26

36

4.18

3.00

2.06

1.17

0.70

60

7.25

7.68

5.53

2.90

2.22

12

0.51

0.67

0.53

0.69

1.05

36

1.26

2.33

1.87

1.09

1.55

60

2.12

4.03

3.02

2.00

5.02

12

1.07

0.41

0.40

0.40

0.27

36

2.55

1.00

0.82

1.00

0.95

60

4.77

2.20

2.06

2.32

2.37

Months From Rating

Œ

„

´

‰

Á

Fixed Income

Universe

Cummulative Excess Returns vs. Category Index
Asset Class

Equity

Allocation

Fixed Income

Universe

12

-0.24

-1.12

-0.97

-0.92

0.70

36

-1.55

-3.56

-3.59

-3.00

0.99

60

-1.46

-5.26

-4.57

-3.96

-1.40

12

0.88

0.32

0.05

-0.20

-0.07

36

2.91

1.31

0.19

-0.06

-0.10

60

4.35

4.07

1.19

0.66

-0.22

12

0.36

0.56

0.32

0.68

1.27

36

0.00

1.20

0.26

0.32

2.22

60

1.60

2.98

1.98

2.60

5.77

12

0.18

-0.41

-0.47

-0.39

0.24

36

-0.06

-1.48

-2.17

-1.48

0.49

60

0.64

-1.64

-2.41

-1.72

0.12

Months From Rating

Œ

„

´

‰

Á

12

0.64

-0.02

-0.58

-0.71

0.67

36

0.02

-0.49

-0.93

-0.95

0.50

60

0.35

-0.12

-0.66

-0.62

0.16

12

1.05

0.57

0.24

-0.10

-0.07

36

0.95

0.59

0.00

-0.03

0.08

60

0.95

0.80

0.43

0.27

-

Annual CAPM Alpha vs. Category Index
Asset Class

Equity

Allocation

Fixed Income

Universe

50

12

0.52

0.48

0.36

0.82

0.11

0.05

0.40

0.12

-0.26

-0.29

60

0.38

0.68

0.39

0.24

0.74

12

0.73

0.22

-0.22

-0.25

0.18

36

0.26

-0.09

-0.58

-0.55

0.26

60

0.49

0.22

-0.31

-0.29

0.23

Morningstar February/March 2018

Finally, while the Analyst Ratings of U.S. funds
generally succeeded in sorting funds based
on future risk-adjusted performance, this was less
evident when measuring based on future
excess returns, especially among stock and bond
funds. To be sure, market conditions have
been challenging for some types of active funds,
and this in turn has likely weighed on ratings
efficacy. But it's important that we achieve greater
separation and slope across the rated universe.
Predictive Power

36

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

Second, at times, we observed that Silverand Bronze-rated funds did not perform much
better than lower-rated funds, on average.
To succeed, the Analyst Rating should predict
differences in future performance, with high-rated
funds outperforming low-rated funds
monotonically. We need to determine ways to
achieve better separation between ratings rungs.

Despite these shortcomings, the findings are
encouraging. It's important to remember
that the Analyst Rating has yet to perform through
a full market cycle, but on balance, the rating
appears to have succeeded in sorting funds based
on future excess returns, though its predictive
power varied depending on the event horizon,
asset class, or measurement technique used. The
findings reveal areas of weakness, and those
insights will animate future efforts to continually
innovate and improve the Analyst Rating. K
Jeffrey Ptak, CFA, is head of global manager research for
Morningstar. He is a member of the editorial board of
Morningstar magazine.



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