Why Do Funds Get Downgraded?

ASK THE EXPERT: Morningstar analysts award Gold, Silver or Bronze Ratings to the funds they consider the cream of the crop. But what leads to a fund losing this crown?

Emma Wall 14 April, 2014 | 8:00AM
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Emma Wall: Hello, and welcome to the Morningstar series, Ask the Expert. I'm Emma Wall, and here with me today is Morningstar analyst, Karine Nowak, to talk about how analysts award funds their medals.

Hello, Karine.

Karine Nowak: Hello, Emma.

Wall: So over the last couple of weeks, there have been quite a few funds who have actually lost their Morningstar rating, Gold, Silver or Bronze, and they've been downgraded. I thought that would be a good opportunity to talk about how funds can be awarded these medals and then also how they could be taken away. So first of, how do you go about analysing funds?

Nowak:  Okay. So, the first thing is our process is actually very qualitative in nature. So, we use this five-pillar framework during our meetings with the managers. So, the five pillars would be People, Parent, Process, Performance and Price.

And some of the things we're going to cover when we talk to a manager, we are going to try to assess how consistent the process is, how repeatable, what type of market inefficiencies they are trying to exploit, and also what resources the manager has around him to actually help him implement his strategy effectively, and actually add value for the investor.

So, performance is definitely an aspect of the review of the analysis, but it's not the only aspect. And when we look at performance, it's very much about the actual expectations we should have from the fund and the actual level of risk that it should be – that the manager is going to be taking within the strategy.

Wall: I mean you mentioned there one of the 5Ps, one the five pillars is Price. Price has really come to the forefront of the private investors mind over the last couple of years because of regulation, because we have suddenly been forced to realize quite how much it costs to invest. So how do you go about analysing price?

Nowak: Price is actually very important. So when we think about price, we try to check and compare versus peers whether the fund is actually very cheap or very expensive and based on – if it's, for example, very expensive, it's going to be, kind of, a negative point for us of the analysis because what we are trying to really check when we think about the price factor is whether the actual performance and the end result for the investor is going to be positive once the process has been taken into account.

Wall: Because obviously if you have great performance, but a high price, the two cancel each other out.

Nowak: Yes, exactly. It's just actually pretty important. When you think about also some of the biggest strategies looking at the price and whether they're actually making the most of the assets that they have to provide, kind of, not very expensive solution for investors, it's quite important.

Wall: So looking then at these recent downgrades, there have been a number of U.S. funds in particular, they have been downgraded. There have been management changes, there have been poor performances. I mean, what can lead to a fund losing that Gold, Silver or Bronze rating?

Nowak: Well, there are different scenarios. So the most obvious is the one you mentioned. If the manager leaves, the fund will almost automatically go into review. So we're going to meet the new manager, try to assess if he is going to use the same process, what his philosophy is going to be, how he is going to make use of the resources in house, and then it may lead us to either downgrade the fund or actually reinstate the positive rating we had before. So, this is one of the potential cases.

Other cases would be if the process changes or if there are tweaks and if it changes our perception of the fund and our expectations, especially in terms of performance and risk, this would be another kind of warning sign.

And the final, let's say, warning sign would be if, for example, performance is not in line with what we would expect given the investment strategy or if the manager is taking more risk than we should expect it's something we're going to raise and discuss with them and it could also trigger potential downgrade.

Wall: So, for example, if a manger who usually invests in U.K. equity large caps than in stocks, putting a considerable portion of his portfolio into small-caps; that would be a flag for you?

Nowak: Yes. It would be definitely because then it would cause us to actually query whether he has got the expertise to actually invest in a small-cap area, if this is kind of more of a structural change or if it's a more of a tactical play on small-caps, in general, and then kind of long term what should we expect in terms of performance because if you say small caps, it would mean ultimately high risk. So, is that what investors are looking for within this type of strategy, it's something we would have to discuss, definitely.

Wall: Karine, thank you very much.

Nowak: Thank You.

Wall: This is Emma Wall for Morningstar. Thank you for watching.

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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Emma Wall  is former Senior International Editor for Morningstar