How Analysts Rate Passive Funds

With an increasing number of passive funds coming to the market, it is quite difficult for investors to sort the wheat from the chaff. But Morningstar helps with this

Emma Wall 28 October, 2014 | 7:45AM
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This article is part of the Morningstar's Guide to Active vs Passive Investing. Click here for our edit on how the experts use the tools at their fingertips, finding out whether you prefer one to the other and examining how to blend active and passive investing for profit.





Emma Wall: Hello and welcome to the Morningstar series, “Ask the Expert.” I’m Emma Wall and here with me today to discuss how Morningstar rates passive funds is passive fund analyst, Jose Garcia Zarate.

Hello, Jose.

Jose Garcia Zarate: Hello.

Wall: With an increasing number of passive funds coming to the market seemingly every day, it is quite difficult I think for investors to sort the wheat from the chaff. But Morningstar helps with this, don’t they? They provide a number of rating measures for people to be able to do that. One of which is the star rating, what exactly is behind that? How does it work?

Zarate: The star rating is purely a quantitative based measure. And it tells you the fund, in this case, a passive fund, has performed on a risk-adjusted basis, against its Morningstar category peers.

Wall: And with passive funds, a lot of that is adjunct to price, as of course, they’re all tracking the same benchmark, so the thing that can make them underperform or over-perform peers is price.

Zarate: Exactly. And the good thing about the star rating even though it’s backward-looking - and this is very important to stress - is that it gives you a measure of how the passive fund has performed, not just against passive peers, but also active funds that provide the same kind of market exposure.

Wall: And the passive analyst fund team, including yourself, also provides shield ratings for a number of tracker funds, don’t they?

Zarate: At the moment what we have done is what is called the Morningstar analyst rating and we’ve rolled out those for traditional tracker funds, particularly those in the U.K. market. And those are qualitative-based, i.e. they are produced by people like me and they’re based on an assessment of the qualities of the fund.

Wall: And that assessment of passive funds is similar to the one that we use for active funds, isn’t it, the 5P process?

Zarate: Indeed it is what we call the 5P or the 5 pillars and those pillars are Performance, Price, Process, Parent and People. People sometimes can be important also for passive funds.

Wall: And I think that’s one of the things a lot of people don’t realize that there is a fund manager behind a passive fund.

Zarate: Yes. Obviously, the People pillar is not going to be as important as for the actively managed funds, but you’re totally right. There are people behind those funds as well.

Wall: Thank you very much, Jose.

Zarate: You’re welcome.

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

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