A Brief History
Morningstar has long given out awards in various markets to recognise those funds and managers who have served investors well. Notably, this does not involve a simple ranking over a year--all too often, the winners in a given year have taken outsized risks to get there, making their performance less than sustain
able. Indeed, funds must have at least five years of history to even be eligible for an award, and it takes more than strong returns to merit consideration.
When Morningstar purchased S&P's global fund data business in 2007, we inherited an awards program that had very similar objectives. For 2008, we have brought the two programs together with the goal of ensuring that the awards go to funds with the best combination of strong recent performance and long-term consistency.
Compare Apples to Apples: Use the Right Fund Benchmark
We will be giving out two types of awards for 2008: Our "Category Awards" recognise funds that have done well versus their peer groups, and our "Group Awards" recognise those fund houses with the strongest line-ups. We'll cover the Group Awards further below, but we'll start by explaining the new methodology for the Category Awards.
The key to judging any fund is to use the right peer group. In the UK, the IMA peer groups dominate the way funds are marketed. Unfortunately, they're overly broad and leave out a huge part of the relevant universe--offshore funds. That's why we use our Morningstar categories as the basis for all of comparative analytics. They include offshore funds, and are drawn specifically to compare like with like as much as possible. In some cases, we'll aggregate categories to obtain a result, but the underlying analysis will always be based on the narrower categories. Take UK Large-Cap Equity funds, for example. We have three Morningstar categories: UK Large-Cap Value, UK Large-Cap Blend, and UK Large-Cap Growth. Funds will be judged relative to those narrower groups, but only one award will be handed out; it will go to that fund deemed to be the best out of all three categories.
Focus on the Long Term
Funds aren't designed for the short-term. They come with costly initial charges and are not well suited to handle short-term trading. Our research has also shown that investors who try to time the market by trading funds generally cost themselves significant performance. Moreover, you just can't tell much from a fund's short-term record: You need to see how it behaves across different market environments to understand if a great year or two might be repeatable, or if they were just the result of a lucky gamble paying off for the manager.
To make sure our methodology doesn’t give too much credit for the short-term, we've created a system that examines fund returns over the past one, three, and five years. Funds are scored by their total return percentile ranks in their Morningstar categories over each period, with 30% of the total score on the one-year period, 16% on the three-year period, and 24% on the five-year period, for a total of 70% allocated to returns.
Risk Adjust Fund Performance
The remaining 30% of a fund's score is allocated to risk adjustment. It's not enough for a fund to have delivered strong returns. After all, the evidence shows that investors make a hash of using volatile funds--they tend to buy near peaks and sell at troughs. And no one likes watching the value of their fund drop by a huge amount.
To adjust for risk, we've used the percentile ranks of a fund's Morningstar Risk score within its Morningstar category. In keeping with our long-term approach, 12% of each fund's total score is based on its three-year Morningstar Risk rank, and 18% is based on its five-year Morningstar Risk rank. We used Morningstar Risk because of its ability to capture investor preferences well. Whereas more typical risk measures such as standard deviation penalise upside and downside variations in returns equally, Morningstar Risk uses the academic concept of utility theory to ensure that funds are penalised more for downside variation. The goal is simple: Investors fear most the risk of loss, so the score should reflect that real-world concern.
As a final check, to be eligible for an award, a fund must have finished in the top half of its Morningstar category in at least three of the last five calendar years. The idea is to ensure that one or two massively good years and three or four subpar ones aren't enough to merit an award. Consistency, then, is the key.
Qualitative Checks
No quantitative system can capture everything that matters. That's why we've built a team of qualitative fund analysts here in the UK, it's why we provide full qualitative research on more than 5,000 stocks and funds around the world, and it's why we are committed to significantly expanding our analyst team across Europe in the coming year. In keeping with that belief, we've added a series of qualitative checks to the awards process. For example, if our fund analysts collectively believe that a fund's fundamental risks are just too high for performance to be sustainable, or if we think changes to the management team or structure of the fund could negatively impact future results, we won't give that fund an award. The awards should be objective, but they should also reflect the knowledge of real risks that our analysts have.
Fund Group Awards
The fund group awards follow very much the same principles as the category awards, but because we wanted to place even more emphasis on the long-term strength of the organisation, we have opted to base the awards on fund houses' average five-year Morningstar Rating across their line-up of funds available to UK investors. The Morningstar Rating uses the Morningstar Risk measure to adjust for risk, and rates funds within their Morningstar categories. In any given category, the rating ranks funds by their risk-adjusted return: The top 10% receive five stars, the next 22.5% receive four stars, the middle 35% receive three stars, the next 22.5% receive two stars, and the bottom 10% receive one star. Qualitative checks also apply to the group awards. For example, if a group has suffered a string of key manager departures that we believe will make it difficult for them to sustain a high level of performance for investors, we may remove the firm from consideration.
Your Chance to Vote
Although we will determine the winners of our fund awards using the above process, we want to hear what you think. Over the next two weeks, we'll be publishing shortlists of potential award winners and asking you to vote for your favourites. We'll be publishing the poll results throughout the period, so please check back often.
