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Thursday, June 19, 2014

Morningstar Analysts Shine Light on Their Process

Reported by Tommy Fernandez

So you probably know of Morningstar's two reporting and rating systems: the Star Rankings and the Analyst Reports.

You may not know very much about what makes them different. Four top Morningstar gurus gave some basics about the second system and how it works.

The four analysts, Russ Kinnel director of manager research; Michael Rawson, analyst covering passive strategies; Katie Reichart, senior analyst covering active strategies and Kathryn Spica, senior analyst covering fund-of-fund strategies, gave two panel talks on the subject at the 2014 Morningstar Investment Conference held in Chicago.

The first important difference to note is this: the Star Rankings system is an objective data-driven historical ranking of the 1-year, 3-year, and 5-year performances of funds. It's pretty straightforward.

The second system is much different. It's forward-looking and based on subjective analyses of fund firms based, firstly, on interviews lots of them with fund employees. These interviews are conducted not only of PMs, but traders, operations folk, CEOs, as many employees that Morningstar analysts can meet to learn as much as possible about the works of the fund firm as a business.

Morningstar analysts take these investigations seriously. They interview between 2,000 and 3,000 fund executives a year and visit over 100 fund families on site.

These investigations follow five tenets: people, parent, process, performance and price.

The goal is to get a sense of whether a fund firm is viable enough as a company, with clearly articulated investment philosophies, disciplined processes, and talented, motivated staff willing to go the distance with the firm, to produce alpha that is worth the price. Data analyses are then done to supplement this picture.

To give an example of the forward-looking thinking, consider the analyst rating downgrade of the T. Rowe Price Equity Income fund from Gold to Bronze. A major driver of this decision was the announcement that 30-year PM Brian Rogers will step down on Oct. 31, 2015.

The rationale: successor John Linehan, who had worked with Jacobs for five years in the firm's Institutional Large-Cap Value strategy, had since 2009 served in the managerial role of head of equities. He's giving up that role to take on the Equity Income fund, but it's unclear how he will adapt.

It's not that senior analyst Reichart, who wrote the June 12 report downgrading the fund, expects that Linehan won't do well, it's just that it remains to be proven. She told attendees that Morningstar still endorses the fund, just with slightly less conviction.

Kinnel leads, every day, two and a half hours of committee meetings on these analyst ratings to give his staff the opportunity to make their case, and then take apart these cases, on various funds.

Another example of forward-looking thinking is Rosen's analyses of DFA, which even though it is a highly quantitative firm that in many ways acts like an index fund really isn't. This is a firm where stewardship stands out and positively impacts many of its funds.

A third example is Spica's recent visit and work on Invesco, looking into its culture and the recent launches of several alts funds -- which she says she is keeping an eye on. 

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