Ratings to refine your portfolio

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Ruth Saldanha: Last week, we talked about how the Morningstar Quantitative Ratings accurately pick funds that would outperform their peers in the panic sell-off before the actual sell-off. That's because these ratings are forward-looking, which means that the highest-rated funds tend to outperform the lesser-rated funds. How can you use these ratings to pick winning funds for your portfolio? Ian Tam, Director of Investment Research at Morningstar Canada is here today to talk about this.

Ian, thank you so much for being here today.

Ian Tam: Thanks for having me, Ruth.

Saldanha: First up, how do quantitative ratings actually calculate future outperformance?

Tam: The Morningstar quantitative ratings use a framework that our analysts use worldwide where we assess the five pillars of a fund's future performance which include the people, so basically how the management team is managing assets, so the talent that the company is recruiting, the experience of the portfolio managers, that type of a thing. We also look at the process. So, is the portfolio manager applying a consistent investment process over time and do they have ways to mitigate risk. We also look at the parent organization. So, we look at the structure of the organization, their ability to retain talent. And we also look at the performance of the fund as well as what it costs to you as investors. So, people, parent, process, performance and price – those are the five pillars that we use to assess the probability that a fund will outperform in the future.

Saldanha: Sometimes different share classes of the same funds have different ratings. Why is that the case?

Tam: Yeah, that's right, Ruth. So, at Morningstar, we have a very explicit focus on fees, because fees at the end of the day are a constant that will negatively affect how much you as an investor receive in your pocket. So, each share class is going to charge a slightly different fee. So, an A share class typically charges a larger fee, an F class usually charges a lower fee in combination with an overall management fee from your advisor.

So, what we do in our ratings framework is we actually explicitly subtract the cost of fees to derive our medalist ratings, so Gold, Silver, Bronze, Neutral and Negative. And because different share classes have different fees, even though the underlying fund is the same, because you are charging – you're being charged different fee by the company, we're actually going to penalize funds that have higher fees. And so, even though a fund can have – the same fund can have different share classes, those two share classes may get different ratings specifically because of the fee.

Saldanha: Let's talk about the 2020 sell-off now. On average Gold-rated equity funds outperformed but not the Gold-rated fixed income funds. Why is that the case?

Tam: It's a great question, Ruth. 2020 first quarter was definitely an interesting one as the global pandemic hit. So, what we've found is when we looked at the negatively-rated fixed income funds through the Morningstar quantitative rating, we found that there was on average a much longer, a much higher sensitivity to interest rates. The technical term for that is duration or modified duration. So, funds that have a higher sensitivity to interest rates, first of all, are taking on more risk than those that are not. And second of all, the first quarter saw two surprise interest rate cuts from the Bank of Canada and the U.S. Fed which really no one was expecting. So, over that very short time period, we did happen to find that negatively-rated funds outperform Gold-rated funds, which is not something we would expect to see over the long-term in the future.

Saldanha: But does this mean then that these ratings work only with equity funds and not with fixed income?

Tam: I wouldn't say that Ruth at all. Over the longer term, since 2018, since the Morningstar quantitative rating was released in Canada, we have found that on average Gold, Silver and Bronze funds do perform neutral and negative if we give it a bit more time, in this case, over a couple of years.

Saldanha: Does this mean that investors should only buy Gold-rated funds?

Tam: The Morningstar quantitative rating is a great starting point for research. And certainly, if you were to pick a Gold-rated fund, very likely that fund will outperform worst-rated funds within the same peer group. So, certainly, a great starting point. Another way to look at things is also to consider Morningstar Star Rating which is the backwards-looking risk-adjusted view of how a fund has performed in the past relative to its peers. So, the combination of those two things might be a good way to again start you points of research. A lot of this of course has to do with your own risk tolerance and the types of products that you are looking for as an investor.

Saldanha: Thank you so much for joining us today, Ian.

Tam: Thanks, Ruth.

Saldanha: For Morningstar, I'm Ruth Saldanha.