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Methodology for Analyst Research on LICs

Morningstar’s qualitative manager research aims to determine which fund managers deserve the attention of investors, and which do not. Morningstar assesses investment managers based on how we believe they will perform in the future over an economic cycle, against both peers and accepted benchmarks. Our model rewards managers which are open and transparent, have a well-run investment process, and importantly, are good fiduciaries of investors’ monies.

In May 2015 we launched Morningstar Analyst Rating™ for LICs - the same ratings scale that we already use for unlisted funds and exchange-traded funds (ETFs). Using the same scale makes it easier for investors to compare investments - whether unlisted fund, ETF or LIC - on an even playing field, regardless of the underlying vehicle’s structure.

The Morningstar Analyst Rating is the final outcome of a collaborative process based on a site visit, the manager questionnaire, quantitative and holdings-based analysis of the portfolio, and an assessment of all the key issues outlined, as illustrated in the diagram below.

 

Morningstar Manager Review Process


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We have translated our former LIC ratings into the equivalent rating in the new scale - click here to see the new and former ratings.

 

By giving a fund a rating, we are expressing an expectation about a strategy’s ability to outperform its relevant performance benchmark and/or peers on a risk-adjusted basis over the long term (defined as a full market cycle). This long-term conviction is summarised through a five-point scale from Gold to Negative. These should be interpreted as follows:

 

Gold

These funds are our highest conviction recommendations and stand out as best of breed for their investment mandate. To earn a Gold rating, a fund must distinguish itself across the five pillars that form the basis of our analysis. That is, a Gold-rated fund should have a seasoned, talented and successful manager or management team; a sound, thoughtful process that has been executed skilfully and consistently; a portfolio that’s in harmony with the stated process and that’s capable of delivering a reward that compensates investors for the risks it takes; reasonable expenses; and a strong parent organisation that is focused on responsible stewardship of investor assets.

 

Silver

Funds in this category are high-conviction recommendations. They have notable advantages across several, but perhaps not all, of the five pillars. With those fundamental strengths, we expect these funds to beat their relevant performance benchmarks and/or peers on a risk-adjusted basis over the long term (defined as a full market cycle of at least five years). While these are worthy funds with many positive features, they don’t necessarily rise to the standard of best in breed. Funds rated Silver may be working their way up our list of recommended picks as we gain more familiarity and conviction in key pillars or working their way down on the basis of a degradation within specific pillars.

 

Bronze

These funds have advantages that clearly outweigh any disadvantages across the pillars, giving us the conviction to award them a positive rating. As is the case with any fund receiving a positive rating, we expect these funds to beat their relevant performance benchmarks and/or peers on a risk-adjusted basis over a full market cycle (defined as a full market cycle of at least five years). Funds rated Bronze may be working their way up our list of recommended picks as we gain more familiarity and conviction in key pillars or working their way down on the basis of a degradation within specific pillars.

 

Neutral

These are funds in which we do not have a strong positive or negative conviction. In our judgment, they are not likely to deliver standout returns but are not likely to seriously underperform either. A fund that is overly benchmark-conscious could receive this rating so long as its fees are reasonable enough to give it a chance of keeping up with the average fund in the category or a competing index fund. Promising but unproven funds may also feature here until we see further evidence that the fund has the potential to outperform.

 

Negative

These funds possess at least one flaw that we believe is likely to significantly hamper future performance, such as high fees or an unstable management team. Because of these faults, we believe these funds are inferior to most competitors and will likely underperform their median peers and benchmark on a risk-adjusted basis in the long term. For example, a fund that combines an overly benchmark-conscious strategy with high fees is likely to get this rating because its strategy lends itself to underperformance.

Morningstar may also use two other designations in place of a rating:

 

Under Review

This designation means that a change at a rated fund requires further review to determine the impact on the rating.

 

Not Ratable

This designation means either that a fund has failed to provide sufficient transparency to determine a rating, or that we are providing information on a new strategy where investors require guidance as to suitability, but there is not yet sufficient information to rate the fund.

 

Morningstar Analyst Rating™ Distribution for Australasian Funds at 30 June 2014


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You can read the full Morningstar Manager Research overview here.

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