Smaller firm makes case for going beyond past performance when evaluating funds

Nov 30, 2017 @ 4:58 pm

By John Waggoner

In the wake of the big public feud between Morningstar Inc. and the Wall Street Journal, advisers are looking for alternative sources of mutual fund analysis — and at least one firm is promoting its differences with the Chicago-based fund research company.

The Wall Street Journal article attacked Morningstar’s ubiquitous star ratings. Morningstar shot back with articles by Morningstar executives Don PhillipsKunal Kapoor and Jeffrey Ptak.

Advisers have generally reacted by saying that they use Morningstar for data, but not for their star ratings. (Funds, apparently, have no problem touting Morningstar star ratings, which was the topic of another Wall Street Journal article.)

The main argument against Morningstar’s star ratings is that they are backwards-looking — that is, they rate a fund according to its past performance, adjusted for the fund’s risk. But past performance is no indicator of future returns. This has prompted research firm CFRA to promote its own rating system, which relies on a fund’s holdings and data from Thomson Reuters Lipper.

“We’ve been educating investors and advisers that they need to go beyond past performance for years, but we think there’s renewed interest from advisers for other tools beyond a solely performance-driven star methodology,” said Todd Rosenbluth, senior director of ETF and mutual fund research at CFRA. “What stands out among the majority of our five-star funds is that they hold securities we view favorably going forward. We’re offering advisers a second opinion of management’s best ideas.”

The process sometimes results in significant ratings differences with Morningstar. For example, CFRA rates American Century Select Fund (TWCIX) five stars, while Morningstar gives it three. (Morningstar’s more comprehensive ratings system awards the fund an analyst rating of bronze, roughly equivalent of three stars.)

“TWCIX is in the top quartile of Lipper’s large-cap growth peer group; has a below-average standard deviation; long manager tenure; a below-average 0.97% expense ratio and modest 16% turnover rate,” Mr. Rosenbluth said. “Meanwhile, the fund’s holdings are considered both attractively valued by CFRA equity analysts and incur modest risk.”

Advisers say they look at several different ways to analyze funds. “We use a great resource called Athena Investment Research because the five-star system from Morningstar is only “rear-view mirror” investing,” said Karl Frank, president of A&I Financial Services. Athena uses behavioral research methodology to evaluate funds.

“We primarily use Morningstar for mutual fund research,” said Sterling Neblett, founding partner of Centurion Wealth Management. “However, we completely ignore the star ratings. I’ve seen five-star funds turn to one-star funds.”

Mr. Neblett isn’t completely negative about Morningstar. “I do look at their new analyst rating system, but don’t give it a major weighting in our decisions,” he said. “We use other internal metrics to identify good managers. Sometimes we will use Zephyr to provide a deeper analysis into certain funds or managers.”