The Morningstar Rating for funds has been helping investors and their advisers evaluate the risk-adjusted return of mutual funds for more than a quarter of a century. You can now research and rank closed-end funds--the collective term that included investment trusts--according to their Morningstar Rating.
Often called the "star rating," this measure is a quantitative assessment of past performance—both return and risk—as measured from one to five stars. The methodology of our rating for U.K. closed-end funds isn't exactly the same as that for open-end funds, but it's closely aligned so that investors can directly compare a closed-end fund's risk-adjusted returns with a similar open-end fund (including exchange-traded funds).
What Is a Closed-end Fund?
The first closed-end fund in the U.K. was launched in 1868 by Foreign & Colonial and offered investors a way to access a broad range of investments. The term 'investment trusts' is more commonly--but incorrectly--used to refer to closed-end funds. The difference rests on a technicality. Both investment trusts and investment companies are closed-end funds with a fixed number of shares in issue, so they aren’t subject to inflows and redemptions. And in both cases, the sole purpose of the company is to invest shareholders’ funds. However, an investment trust is actually just one kind of investment company. And to be so, it must meet specific requirements laid out in Section 842 of the Income and Corporation Taxes Act 1988, which state that:
An investment trust:
--Cannot invest more than 15% of total assets in one single company
--Must be resident in the U.K.
--Cannot be controlled by fewer than 5 people
--Must quote its ordinary shares on the London Stock Exchange
An investment company, on the other hand, is a term used to describe any closed-end investment company - of which an investment trust is one. As well as including investment trusts that meet the criteria of Section 842, the term also includes companies that are incorporated outside of the UK and listed on other exchanges. Read more here.
Closed-end funds pioneered the way for mutual funds in the U.K. and until 1929 they were the only collective investment schemes on offer. Read more about closed-end funds in our CEF Education Centre. At our CEF Centre you can sign up for our monthly CEF newsletter or rank funds by Morningstar Rating.
Methodology
The Morningstar Rating for closed-end funds is calculated using net asset value rather than share price and is recalculated every month. Ratings are based on risk-adjusted returns for the 3-, 5-, and 10-year time periods, and then the overall rating is a weighted average of the available time-period ratings. Closed-end funds are rated against a peer group of open-end funds in the same Morningstar Category.
Morningstar calculates risk-adjusted returns for all funds by starting with total return and then adjusting for the risk-free rate, and volatility. Morningstar uses total returns based on net asset value, instead of market price, for the closed-end fund rating. Net asset value returns are most comparable with open-end fund returns, and do not rely on market data that could be subject to the influence of market sentiment.
Morningstar adjusts for both the fund's excess return over the risk-free rate and for volatility. These steps in the rating methodology are identical for closed-end and open-end funds, and the result is the Morningstar Risk-Adjusted Return. Morningstar’s risk adjustment is based on expected utility theory. Morningstar measures the amount of variation in the fund’s monthly returns and how investors would trade off return for less risk.
In the final step, Morningstar assigns ratings to closed-end funds by comparing them with their open-end peers, as explained below, thereby making the closed-end fund ratings more readily comparable with the open-end fund ratings. The open-end universe is larger and it forms a more representative peer group for comparisons than closed-end funds alone. Note that the Morningstar Rating for open-end funds also adjusts for the sales charges incurred by the investor.
How Does It Work?
Morningstar rates open-end funds against their category peers using risk-adjusted returns and the distribution shown in the graphic below. The breakpoints between each rating level are recorded, and then Morningstar rates closed-end funds by comparing their risk-adjusted returns to these breakpoints. For example, the illustration shows sample breakpoints for the UK Large-Cap Blend Equity open-end category for the three-year time period. A closed-end fund in that category with a risk-adjusted return of 8.2% would receive a 4-star rating for that time period.
Next Steps
The Morningstar Rating is a quantitative rating. But we're not going to stop there. As with Morningstar's analyst-driven qualitative ratings for open-end funds in Europe and Asia, which were launched in February 2009, our closed-end fund analysts are working on a qualitative rating that will be launched shortly, allowing you to hear direct from our research team on their views of specific closed-end funds.
