Morningstar is taking the wraps off a new ratings system that is likely to shake up the current list of winners and losers. The new ratings will no longer pit all stock funds against each other. It will also reward funds that hold down losses, even at the expense of overall performance.

As the majority of net sales follow highly rated funds, the revamp in the ratings system could have a large impact on the sales of fund groups. Before the rise of the Web, Morningstar ratings were thought to account for up to 90 percent of fund flows.

Fund firm executives interviewed by MFWire.com said that though they were aware of the changes in the ratings, they were not yet certain how their funds would be affected.

"Morningstar stayed in touch with us through the process," said one executive.

The Chicago fund-tracker is making the changes to reflect the way investors now purchase funds, said Don Phillips, Morningstar managing director. He explained that most investors no longer own just one or two funds and that they are looker for funds that fit a specialized role in a portfolio.

The new ratings ensure "that a high rating results from superior performance, not a 'tail wind' effect caused by the outperformance of a particular area of the market," explained Phillips.

The new ratings are less likely than the old ratings to reward funds for spikes in performance or from being in a hot asset class. In periods like the NASDAQ run up from 1998 to 2000, the new system would likely have favored steadier, diversified funds more than the old system did.

The changes to the system are set to go into effect in July and the first ratings will be based on data gathered from June 30, 2002.

Rather than assigning star ratings within four broad asset class categories, funds will be sized up within 50 more narrowly defined groups. That means that funds in a hot asset class (think small cap value today) will no longer rank better than funds in a cold objective (think aggressive growth). Instead, only the top funds within each objective will receive top ratings.

The new ratings will use the same scale of one to five stars assigned on a bell-curve. They will also be load-adjusted. The new star rating uses an enhanced risk-adjusted return measure and accounts for all variations in a fund's month-to-month performance, with more emphasis on downward risk.

The enhanced risk-adjusted return measure is based on "expected utility theory," explained Morningstar, which recognizes that investors are a) more concerned about a possible poor outcome than an unexpectedly good outcome and b) willing to give up some portion of their expected return in exchange for greater certainty of return.

The firm will also de-emphasize historic ratings of funds that switch objectives. Morningstar officials explained that the change was made to keep fund firms from having an incentive to change the fund objective to gain a better rating.  

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