Originally created 05/05/02

Morningstar retooling star system



NEW YORK -- Morningstar Inc., known for its five-star ratings of mutual funds, is revamping its system to reflect the huge growth in an industry where U.S. stock funds alone now number 14,000.

The new Morningstar Rating system, which goes into effect in July, is designed to rank funds more fairly than the method introduced back in 1985.

The biggest, most important change involves how funds are grouped and graded. Under the current system, funds are rated within four broad asset classes: U.S. stock, international stuck, taxable fond and municipal bond. There is no division by investment style or size.

The new system will rank funds within 50 more specific categories. Growth funds will be separated from value funds. Funds will also be sorted by the size of companies on which they focus - large, mid and small capitalization.

The changes address concerns of critics who said Morningstar's old approach favored the investment style with the best performance at any given time - like growth funds during the late '90s bull market and value funds in the current bear market.

There's evidence to support that the ratings have favored the style that's hot. Consider that now there are 43 large-cap value funds that have five stars, while only five large-cap growth funds do. As for one-star ratings: 168 large-cap growth funds get that weakest mark, while only 10 large-cap value funds do.

With the new ratings method, "You get rid of the head winds and the tail winds. You make it easier for people to buy a quality fund in an out-of-favor sector of the market," said Don Phillips, Morningstar managing director.

Phillips said growth in the fund industry compelled Morningstar to make the changes.

"Fifteen years ago, you had funds with very nonspecific names. There wasn't a single fund with mid-cap value in its name," Philips said.

Financial advisers said the changes will help investors make better, more well-informed decisions.

"It's going to make those star ratings much more meaningful," said Patricia Jennerjohn, a certified financial planner in Oakland, Calif.

Bob Glovsky, a certified financial planner in Boston, said: "It's the fairest way. It compares funds against their peers. Lumping them together made no sense at all."

Still, planners say investors shouldn't get star-struck.

"People want to believe, 'If I buy a five-star fund, I'm OK.' Regardless of how the stars change, if it were as easy as buying five-star funds, if that's all there is, everybody can do it," said Joel Javer, a certified financial planner in Denver.

Javer's advice: "Do a little more homework going into it, rather than having blind faith in someone else's research."

Looking beyond stars and ratings, here's what the pros say investors should do before buying a fund:

- Find out as much as you can about the fund's manager. Was the current manager in charge when the fund did incredibly well or when it had a bad spell? Javer urges investors to call the fund company to ask if profiles of fund managers are available.

- Look at the size of the fund itself, and remember that bigger doesn't mean better. "If the fund has done well and attracted a lot of cash, it becomes more difficult to manage," said Scott Bordelon, a certified financial planner in Covington, La.

- Analyze the fund's performance over individual years, rather than looking only at annualized three-, five- and 10-year returns, which could be skewed by one really good or bad year. "I would look at how the fund did in the growth spurt from 1997 to 1999. Are those returns making you think they have done well for five years, but in truth they did well in '97 through '99 and then fell off the cliff in 2000 and 2001?" Javer said.

- Glovsky, the financial planner in Boston, recommended looking into a fund's history to find out if it has long been the kind of fund it says it is - mid-cap value, large-cap growth or whatever.

"Look for consistency of style," Glovsky said. "Has it always been in the category that Morningstar is putting it in? Or, has the category moved a lot, in which case you don't have a lot of predictability."

- Diversify your fund holdings. If you buy only high-flying tech funds - as many did in the late '90s - or just small-cap value funds as many might want to do in today's market, your entire portfolio will suffer when that sector stumbles.

Remember, said Jennerjohn, the financial planner in Oakland, Calif., "In any well diversified portfolio, a couple of things aren't going to be doing as well at every point in time."