A friend and I recently ate at a highly-regarded Toronto restaurant rated five stars by a well-known and typically reliable food critic. We were both underwhelmed by our underseasoned, overcooked dishes, leaving us wondering what the critic was thinking. I later learned the restaurant's long-time chef and his staff had recently left to set up shop elsewhere. The high rating therefore reflected how good the food used to be, not how good it is now.
That the future doesn't reflect the past isn't news to most investors, yet many rely heavily on backward-looking ratings like the Morningstar Rating to make decisions. The Morningstar Rating, commonly referred to as the Star Rating, plots funds' risk-adjusted returns over three, five and 10 years against their relevant peer groups along a bell curve. The funds with the best historical risk-adjusted returns earn 4- and 5-star ratings.
Although our research in the U.S. suggests the Star Rating has been mildly predictive of future performance, we've always said the rating is no slam dunk. Because it is backward-looking, it won't tell you whether a manager or strategy has changed. Even if that's not the case, the rating can be strongly influenced by market conditions. In the mid-2000s, for example, some funds garnered 5-star ratings because their portfolios were chockfull of high-flying commodity stocks, not because their managers were especially skilled. Lastly, over shorter periods, funds can be successful simply because of random chance. (The star rating measures up to 10 years of returns, but performance over the three- and five-year periods can strongly influence the rating.) These funds may be at the top of the heap for a brief spell, but that's unlikely to remain the case over the long haul.
A better view of the future
While the Star Rating looks backward, relies solely on performance and is purely quantitative, the Morningstar Analyst Rating is fundamentals-based, qualitative and forward looking. The Analyst Rating is based on analysts' comprehensive assessment of the people, process, performance, parent and price supporting a fund -- the five pillars of Morningstar's approach to research. We consider whether a fund has a competitive advantage in each of the five areas.
Instead of stars, analysts award medals -- Gold, Silver or Bronze -- based on the strength of these advantages. The more precious the metal, the more confident we are in the fund's ability to deliver above-average risk-adjusted returns versus peers and/or benchmark over a full market cycle. We assign Neutral ratings to funds with no clear competitive advantages or glaring disadvantages, while funds likely to underperform get Negative ratings. Because the Analyst Rating is forward-looking, it won't always match the backward-looking Morningstar Rating.
Analysts draw upon quantitative data to evaluate performance and to understand how a manager invests, but that's not the end of the story. Returns alone won't tell you whether a manager's temperament matches her strategy or whether she has strong research at her disposal, for example.
Even in instances where the numbers appear to tell a cut-and-dried story, the truth may be more complicated. A fund may have excellent long-term returns, but if the fund has become too big to invest in the small-cap names behind its winning record, it may have a tough time replicating its past. Or it may be the case that performance appears mediocre, but that's only because the strategy has been out of favour. In this case, the future may be better than the recent past.
Past isn't prologue for these medalists
Rated 1-star, Manulife Strategic Income 
looks pretty shabby on paper. The problem is the comparison group. The fund lands in the High Yield Fixed Income category, but because its portfolio is more diversified by asset class, geography and credit quality than its rivals, the peers aren't the best reference point. Next to the fund's benchmark, the Barclays Multiverse Index, performance looks terrific. (Returns have also been more correlated with the global high yield group, which it has also beaten.) More importantly, manager Dan Janis is backed by a deep and seasoned analyst team that has been able to move adeptly between high-yield and investment-grade corporate bonds, foreign government debt, non-agency residential and commercial mortgage-backed securities, bank loans and convertible bonds since taking charge in 2005. The U.S.-based version of the mandate has also been a success. The fund's relatively high 2.06% MER dampens our conviction, though its Bronze rating signifies our belief it will likely outperform.
We also give NEI Ethical Global Equity a Bronze rating despite a 2-star Morningstar Rating. It's an example of where the Star Rating says more about near-term performance than long-term fundamentals. The fund's relatively poor returns since subadvisor Manning & Napier took over in 2006 is mostly thanks to its rough stretch in 2009 and 2010. Every good fund inevitably suffers ruts like these, and it's a mistake to fixate on two bad years at the expense of management's long record of doing better at U.S.-based funds like Manning & Napier World Opportunities, where it has posted benchmark-beating returns for a couple of decades. (Our U.S. analyst team rates M&N funds under coverage Gold.) A big, experienced analyst staff and a flexible strategy boost its appeal. Again, a high price tag diminishes our enthusiasm, and we acknowledge returns have been surprisingly weak. These factors keep us from rating the fund more highly.
Lastly, Beutel Goodman International Equity , rated 1-star, hasn't matched the successes of its siblings in the Beutel Goodman family. There's no sugar-coating the fund's past performance, especially in 2009 and 2010, but managers KC Parker and Colin Ramkissoon took charge in 2011 and 2013, respectively. It's too early to pass judgment on their record thus far, but they have a few things arguing in their favour. For one, they employ Beutel Goodman's disciplined value strategy, which has been the recipe for success at Gold-rated Beutel Goodman Canadian Equity . The managers have been prudent in adapting BG's approach internationally. Their portfolio, while still compact, is a bit broader than its equity fund siblings. The team is also more cognizant of macroeconomic and currency risks. The managers will have to work together longer for us to increase our conviction, but its Bronze rating signifies we still think it's likely to outperform.
Conclusion
We're not suggesting that the Star Rating isn't useful. Because of the time-intensive nature of our research, analysts rate fewer than 200 of the more than 3,000 unique funds in the Canadian universe. One virtue of the Star Rating's quantitative approach is that it can be applied to any fund with at least three years of history. While not perfect, it at least tells you something about a fund's past achievement. It should never be viewed as a buy signal, but the rating isn't a bad way for an investor to narrow down a vast universe.
Of course, winnowing the investment universe is one of the main reasons we created the Analyst Rating. It's important to remember, though, the Analyst Rating doesn't free you from doing homework of your own. The rating indicates a fund's likelihood of outperforming its benchmark and/or peers, but it won't tell you whether the fund is right for your portfolio or whether it matches your risk tolerance. What's more, investors need to understand any investment before making one. If you don't know why you own something to begin with, you'll have a tougher time determining whether you should still own it in the future.
