Perhaps the most difficult thing to do as an analyst is to put your neck out and make a call on a security. The best analogy we have is that of a referee who calls a game-changing penalty at a crucial moment in a football game: One team's fans are going to agree with the call; the other team's fans are going to disagree; all will be vehement in their opinion. We mean this as a fact, not as a complaint. After all, making calls is a large part of the job and, ultimately, it's the only part that matters. We can pontificate on various aspects of investing all day long, but if we end up with the wrong conclusions, then what's the point of pontificating?
Launching ratings on investment trusts and other closed-end funds was a big step for us and we largely followed the lead of our open-end analyst colleagues. While our Analyst Rating methodology document draws heavily on Morningstar’s open-end fund research, we also have our own version for investment trusts.
We published this document not only to lay out the objective and process for the ratings, but also to serve as the basis for the inevitable scrutiny that comes about when making calls. Much of that document was written by our open-end fund analyst colleagues, but in places we felt it necessary to tweak certain elements for investment trusts. After all, items like discount control mechanisms and gearing are not commonplace with OEICs and unit trusts. In places, then, there are slight but nonetheless meaningful differences between the open-end fund and investment trust rating methodologies.
Not the Morningstar (Star) Rating
Perhaps the biggest area of user confusion so far has been between the Star Rating and the Morningstar Analyst Rating. To put it in simple terms:
- The Star Rating relies on historical risk-adjusted performance against a peer group;
- The Analyst Rating is qualitative and forward-looking. Historical performance plays a lesser role in the rating, with the focus on the fund’s managers, the investment process and the board and parent firm.
If you're interested, the methodology for assigning the Morningstar (Star) Rating can be found here. I would like to point out two things related to the Star Rating. First, while it is a backward-looking assessment of a fund's risk-adjusted (risk equating to net asset value volatility) total returns, it's not typically a simple risk-adjusted total return assessment. For funds with more than five-years’ worth of history, the three-year and five-year and (for funds with a long history) 10-year ratings are combined into one overall rating, which means that the most recent period is more heavily weighted than older periods. This becomes important when we think about the performance pillar for the Analyst Rating because we want to look at how a fund performs on a risk-adjusted basis on a month-to-month and rolling-period basis. The near-term performance weighting in the overall Morningstar Rating versus a monthly assessment is a big differentiator between the star rating and the performance pillar of the Morningstar Analyst Rating process.
Second, the Morningstar Rating compares a fund's risk-adjusted performance against that fund’s category peers. So, if the fund is a UK large-cap value equity fund, it is compared against other UK large-cap value equity peers, irrespective of the fund structure. We believe investors don't care whether they invest in an asset class or sector via an open-end, closed-end or exchange-traded fund; we believe that investors know what sector they want to invest in, and simply want to know what funds—regardless of structure—are more likely to get them to their destination. As such, when we assess past performance, we look at an investment trust’s risk-adjusted net asset value total returns against the category averages for other investment trusts, for open-end funds and for ETFs.
Objective of Closed-end Fund Analyst Ratings
You have to begin with the end in mind. The Morningstar Analyst Rating is the summary expression of our forward-looking analysis of a fund. The difference between ratings corresponds to differences in our level of conviction that the fund will outperform its peers over a market cycle, which we've taken to mean five years. Essentially, a Gold rating means that we have the highest conviction that the fund will, more often than not, beat its category average peer on a risk-adjusted basis over the next five years. A Silver or Bronze rating would also show we have conviction, but we may also have some reservations—more so at a Bronze-rated fund than at a Silver one.
I want to be absolutely clear on four things with regard to the objective, because I realise that questions about ratings now will eventually turn into assessments of our ability to rate funds.
First, we are looking long-term, over a market cycle, which we have defined as being five years.
Second, we are making a call on risk-adjusted performance. By risk-adjusted, we are using Morningstar Risk-Adjusted measures, as defined in the Morningstar Rating methodology document (here).
Third, we are looking at net asset value total returns—not share price total returns; the upshot being that a fund could have great NAV performance and still underperform on a share price basis.
Fourth, we are looking at performance in relation to the investment trust’s Morningstar category average peer, regardless of whether that peer is a closed-end fund, an open-ended fund or an ETF; we aren't going to benchmark performance against some customised list of funds or funds that look like they should be peers; we aren't going to consider performance against the top decile performance.
One Last Thing
There is also the subject of premium and discounts. Our ratings are concerned with the investment trust and its NAV total returns. We are essentially making a call on whether a fund is a good investment vehicle to help you reach your investment goals. We are not making a market call, though.
Mike Taggart, CFA, Morningstar's director of closed-end fund research in the US, co-authored this article.
