CHICAGO -- Investors familiar with Morningstar Inc.'s 5-star system for rating mutual funds will soon see ratings based on an "AAA" scale as well.
The company announced plans last week to assign "Analyst Ratings" to supplement star ratings beginning this fall.
"The star system has limitations, and we want to be up front about that," Don Phillips, Morningstar's president of fund research, said at the company's annual investment conference.
Star ratings are based on measures of a fund's past performance, including returns compared with those of similar funds and the level of risk the fund took to achieve those returns.
The analyst ratings will assess factors such as judgments of the strengths of a fund's managers and parent company and whether they have a well-designed system to select investments.
Morningstar has assigned star ratings for more than two decades. Four-star and five-star ratings can entice investors to choose a fund that has turned in strong performance recently. But a stock or bond that produced standout performance eventually drags when the market shifts and those investments fall out of favor. That can lead to disappointing returns for those who invested in the fund too late, and turn a 5-star fund into a 4-star fund, or lower.
On the flip side, historically strong-performing funds backed by solid managers can end up losing a star or two after a bad stretch of performance. But such funds often come back, rewarding investors who stuck with them.
"We want to give people some conviction to stay with the quality fund," Mr. Phillips said.
Like the star ratings, the new system will use a five-level scale. Top-rung "AAA" funds are those Morningstar believes are in best position to deliver strong returns. "AA" and "A'' funds are seen as less likely to do well but are still considered to have positive ratings. "Neutral" ratings will be assigned to funds that aren't likely to deliver standout returns, either for the better or worse. A "negative" rating signifies a fund that Morningstar considers inferior.
The ratings will be based on quality of fund manager, quality of investment process, quality of fund's parent company, evaluation of long-term returns, and evaluation of the expenses the fund charges.
Investors researching a fund on Morningstar's Web site will see the fund's analyst rating above its star rating.
Morningstar plans to assign analyst ratings to as many as 200 funds beginning in October, starting with funds that draw the most investor interest and assets. Over the next year, Morningstar hopes to rate more than 1,500 funds, holding more than 80 percent of fund industry assets.
The analyst ratings will be assigned to funds that are new and old. That differs from the star ratings, which Morningstar assigns only to funds with performance records of at least three years.