In the index post a few weeks ago I promised to go into more detail on the Morningstar fund ranking process. This is rather arcane for most individual investors, but other financial professional should find it interesting.
When you see a “Rank in Category” number on the performance page of Morningstar, here is what you actually get. They take all of the funds in that particular category and sort them by performance (on a timeframe anywhere from 1 day to 15 years). Then they figure out which percentile each fund fall in compared to its peers (1 is best, 100 is worst). So far so good. Exhibit 1 shows the number of funds in style-box categories. This is where it gets tricky: all share classes of a particular fund get ranked. For example, there are 1,703 funds ranked in the Large Growth category. But “only” 439 unique portfolios, which means they rank on average 3.9 share classes of each fund. It’s a little unfair to compare high expense B and C shares which might have very low AUM against lower cost options. This also means that ultra-low-cost index funds (such as Vanguard’s that I looked at) get a higher ranking than they would if you wanted to look at where the dollars actually are.
Exhibit 1 – Number of Fund in Each Morningstar Style-box Category
Average of 3-4 share classes doesn’t seem so bad, but there are some major outliers with American funds taking the cake with 19 share classes for most of their funds! Let’s take the Growth Fund of America as an example to see how that works (Exhibit 2). I also included the Vanguard Growth Index fund to illustrate the point. And note that the Morningstar exacerbates the issue with adding the “.LW share class” for each A-share fund. They are just an internal way for them to remove the impact of sales commissions, but they still get counted as another “fund” although the rankings and returns are exactly the same as A-shares.
Most of the cheaper classes accounting for 95% of the fund’s AUM have done better than the index. But a few crappy shares fall below. What strikes me is the range: 0.9% spread in YTD returns and almost 10 percentage points in rankings. Think about it – ranked on YTD performance as of Sep 30, there are 186 funds between the best and worst share class. And it’s the exact same fund with the only difference being expense ratios and 12b-1 fees!
What? Seriously? Why does American have 19 share classes in this day and age of RIAs and AUM fees?!? I’ll do a separate post reviewing why they “need” so many and what the differences are.
Exhibit 2 – Share Class Rankings of The Growth Fund of America
Now we come to another complicating point that I mentioned before – you can’t look at ETF rankings to see how that index compares to active managers in that category. Morningstar has separate ranking for open-end mutual funds and ETFs and they don’t mix together. That’s why you have to look for Vanguard open-end passive funds to see how indexing is doing vs. the active peers. To be fair, of the 1,648 funds in the Large Blend category 240 are classified as index funds. And some of them get into the same shenanigans, such as the 10 share classes of the Principal Large Cap S&P 500 Index. There is also a number of smart beta index funds in there. Luckily, the investors have mostly chosen to ignore the funky ones and most of the AUM is in Vanguard and Fidelity Spartan index funds.
For the ETF performance rankings, the field is significantly smaller (Exhibit 3). Sadly, of the 87 Large Blend ETFs, I only count 19 that are traditional cap-weighted index funds (total market, large cap and mega cap varieties). The other 67 are different flavors of smart beta and just looking at their names makes my head hurt.
Enhanced, volatility, capex, revenue, earnings, beta, activist, FactorSelect, dividend, dividend growth, ex this ex that, buybacks, strong dollar/weak dollar, risk aware, wide moat, tactical, Plus, AlphaDex, Buy-Write, rotation, momentum.
But I digress…
Exhibit 3 – Number of ETFs in Each Morningstar Style-box Category
Oh yeah, just in case you weren’t confused enough, MS rankings for ETFs are based on NAV performance, which can be quite different from the price performance ranking (and unlike open-end funds, real investors get the price, not NAV).
So have fun trying to make sense of fund rankings. With the coming advent of active ETFs, I think Morningstar should really do away with separate fund/ETF systems and combine all the investment vehicles into one big ranking pool (including the closed-end funds for that matter).