Morningstar Analysts Now Rate Index Trackers

You can now compare passive funds such as trackers with their actively-managed counterparts, helping you make better investment decisions

Ben Johnson 3 December, 2013 | 3:24PM
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Today, we are pleased to introduce forward-looking, analyst-driven fund ratings for 25 of the most popular index funds in the UK. Each of the funds has been assigned a Morningstar Analyst Rating for funds, which supplements the Morningstar Rating for funds (commonly known as the "star rating"). The star ratings assign a fund one to five stars based on its risk-adjusted past performance versus its peers in the same category. In addition, we have now launched in-depth Analyst Reports for the newly-rated tracker funds so investors can benefit from our analysts' opinion on these funds' future prospects.

The growing popularity of index funds and exchange-traded products in the wake of the implementation of the Retail Distribution Review has underscored the need to expand the reach of our research efforts into the realm of traditional tracker funds and to measure them using the common global standard that is our Morningstar Analyst Rating. This research will ultimately help British investors to make better informed decisions when selecting funds.

What Do Our Analyst Ratings Mean?

The five-tiered Morningstar Analyst Rating scale has three positive levels—Gold, Silver and Bronze—in addition to Neutral and Negative ratings. Analysts arrive at a rating through an evaluation of five key pillars they believe are crucial to predicting the future success of a fund, considering both quantitative as well as qualitative factors: People, Process, Parent, Performance and Price. Morningstar analysts score these five pillars as Positive, Neutral or Negative, which are then combined for the overall rating. The Morningstar Analyst Rating Methodology Document can be found here.

The Analyst Ratings are not designed to be a market call on an asset class or a prediction of short-term performance, and cannot assess whether a fund is the right fit for an investor's particular portfolio or risk tolerance.

Morningstar reserves the Gold, Silver and Bronze ratings for funds its analyst team thinks have sustainable advantages that position them well versus peers and/or a relevant benchmark on a risk-adjusted basis over a full market cycle of at least five years. Put another way, over a five-year period funds rated Gold, Silver or Bronze should outperform their peers, with Gold being the most outstanding outperformer.

Of the 25 index funds that we have rated, we have assigned nine with a Morningstar Analyst rating of Silver, while 14 have been rated Bronze, and the remaining two were given a Neutral rating (click on the table below for full details).

Comparing Trackers to Other Funds

While the pillars of our analysis are the same regardless of whether we are rating a passively-managed index fund or an actively-managed fund (OEICs, unit trusts and investment trusts), their relative rank in our overall assessment of a fund differs somewhat between the two. Specifically, costs and benchmark-relative performance receive greater scrutiny in assessing the investment merit of index funds.

Obviously, keeping costs—both explicit ones, such as the expense ratio, as well as implicit ones, like the cost of portfolio turnover—at a minimum is paramount in the context of running an index-tracking fund. As such, it should come as no surprise that the top-rated funds that we have analysed are amongst the lowest cost investment options, not just versus their actively-managed peers in their Morningstar Categories but also relative to comparable index fund and exchange-traded fund (ETF) options.

While costs are paramount, they are just one component of our holistic assessment of these funds. We also closely scrutinise their performance relative to their peers in their Morningstar Categories, which include actively-managed funds as well as index funds and ETFs. The composition and rules of construction of the fund's benchmark index are also carefully analysed. Stewardship, i.e. the parent company's approach to helping investors, plays a vital role in our analysis. We tend to favour parent firms that put investors' interests ahead of commercial goals and that align fund managers' incentives accordingly. Of course, the skills and experience of the people managing the fund are an important factor in our analysis. In the management of index funds, every 0.01% of performance counts, so it is vital to have experienced managers at the helm.

In sum, we reserve our positive ratings for those funds that are best-suited to deliver precise tracking at a very low cost over a long timeframe—ones backed by experienced managers and sponsored by firms that are good stewards of investors' capital.

Our Index Fund Ratings

(Click table to enlarge)

The information contained within is for educational and informational purposes ONLY. It is not intended nor should it be considered an invitation or inducement to buy or sell a security or securities noted within nor should it be viewed as a communication intended to persuade or incite you to buy or sell security or securities noted within. Any commentary provided is the opinion of the author and should not be considered a personalised recommendation. The information contained within should not be a person's sole basis for making an investment decision. Please contact your financial professional before making an investment decision.

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About Author

Ben Johnson

Ben Johnson  is director of passive funds research at Morningstar.