A new `star’ to rise: Custom risk ratings

In an era when everything from chinos to computers can be tailor-made, it was inevitable – customized mutual fund ratings.

Morningstar Inc., the company that did for mutual fund ratings what Siskel and Ebert did for movie reviews, hopes to introduce to financial advisers next year customized fund reviews based on investors’ appetite for risk, InvestmentNews has learned.

As a first step toward eventually customizing risk ratings, Morningstar also plans to modify how it defines a fund’s risk.

The changes would go beyond the Chicago company’s plans, unveiled last week, to revamp its 17-year-old star ratings.

“We will continue to float the idea to advisers to see what kind of reception it gets,” says Don Phillips, Morningstar’s managing director. “But my intuition tells me it’s something that would be very popular.”

Some skepticism

The big question, of course, is whether advisers are interested in customized fund ratings.

Although the bearish stock market has pushed risk-aversion higher on the list of priorities of many investors, Morningstar still faces an uphill battle to get advisers to embrace customized risk ratings.

“I am skeptical,” says Andrew Tapparo, president of Tapparo Capital Management, a Topsfield, Mass., firm that oversees about $22 million in assets. “Everyone, it seems, is trying to quantify risk tolerance. And, basically, they’ve all been wrong.”

Nevertheless, Mr. Tapparo says he would probably give Morningstar’s customized ratings a try.

“It does seem like they are trying to take things to another level,” he says. “Unfortunately, I’m a little jaded.”

Along with details about how the company plans to rate funds against a smaller group of peers, Morningstar last week revealed yet another change that may prove significant to advisers.

The current system measures a fund’s performance relative to the 90-day Treasury bill. As long as a fund beats the benchmark each month, it is deemed risk free.

But that method ignores the fact that volatile funds – even upwardly volatile funds – are likely eventually to produce losses.

Remember Internet funds? Returns on them soared to dizzying heights in late 1999, only to crash and burn months later.

Starting July 1, Morningstar will calculate risk based, in part, on expected-utility theory.

Essentially, the theory holds that as a person’s wealth rises, each dollar is worth less to that person than the previous one. The new methodology takes both upside and downside risk into account – with slightly more emphasis on the downside.

The switch to the new system provides a steppingstone to customized fund ratings.

“We could not have built a bridge to that place using the old methodology, but we can from here,” Mr. Phillips says.

The new customized ratings would work something like this: After an adviser measures a client’s tolerance for risk – using either a questionnaire provided by Morningstar or the adviser’s own – the information would be added to Morningstar’s database.

Morningstar would then rate the funds it tracks based on the level of risk that the client is willing to tolerate. A fund that is deemed risky for a conservative investor might be judged suitable for a more aggressive investor.

“No one benefits from a mismatched sale,” says Mr. Phillips. “It’s all about mapping the right investor to the right fund for the right reason.”

Broader changes

The new method of calculating risk is part of a broader change in the way Morningstar rates funds.

Under the current system, funds receive star ratings based on their relative performance in four broad categories: U.S. stock funds, international stock funds, taxable bond funds and municipal bond funds.

Starting this summer, Morningstar will rate funds based on 48 investment categories.

As a result, some funds with low returns, or even losses, will receive the enviable four- or five-star rating, as long as they outperform their peers.

The new system, which took more than a year to develop, will result in rating changes for about 25% of the 4,873 funds given ratings by Morningstar.

The transition, however, is unlikely to faze advisers. Many advisers – in sharp contrast to do-it-yourself investors – have long recognized the failings of the old rating system and don’t rely on it.

“I’ve always felt the star system was too obscure,” says Paul Seibert Jr., an adviser based in Sandwich, Mass.

“It’s never been made entirely clear to me what they are actually based on. It seems like they are based on someone else’s opinion,” he says.

Mr. Seibert, like other advisers contacted by InvestmentNews, usually gives a fund’s star rating little more than a passing glance.

“Sometimes I’ll check a fund’s rating just to make myself more comfortable with my own selection,” he says.

Although the change isn’t likely to affect many advisers, it’s sure to make for some lively discussion at most fund companies.

Over the years, fund companies have come to rely on the ratings to attract investors to their funds. The ratings appear regularly in mutual fund advertisements.

Between January 1998 and this February, four- and five-star funds took in a net $720.4 billion, and funds with one, two or three stars posted outflows of $384.0 billion, according to Financial Research Corp. in Boston.

By rewarding fund managers across all fund categories – particularly those competing in out-of-favor investment styles – Morningstar’s new star system may discourage managers from drifting outside their categories to boost returns, says FRC analyst Christopher Brown.

“Under the old system, there was more impetus for managers to stray from their stated investment styles,” he says.