CHICAGO - International and global equity mutual funds finally will be ranked against their peers in a new star rating system Morningstar Inc., Chicago, is expected to announce this week.
International money managers are pleased with the change, which they say is long overdue. Until now, international equity funds had been compared against the whole universe of equity funds.
More five-star ratings for international equity funds might give both institutional and retail investors the confidence to increase their allocations to non-U.S. and global stock funds.
The international ratings are only part of changes Morningstar is to announce; the company wouldn't reveal any other details as Pensions & Investments went to press.
Money managers have long argued for a separate rating class for international funds, which have looked particularly bad in terms of risk-adjusted performance during the past five years.
"We've said for a long time that international equity should be a separately rated class of funds," said Steven Norwitz, vice president, T. Rowe Price Associates Inc., Baltimore. "By combining international with U.S. equity funds, international funds that were doing very well in their peer class looked like laggards compared to the overall universe. It's often the situation that the fund wasn't lagging, but that international markets were performing poorly."
While both supporters and critics of Morningstar's system and Morningstar itself hasten to say the star system should only be the starting point of a fund evaluation, consultants say reliance on the rating system is heavy.
"As much as you tell plan sponsors and how ever much Morningstar tells them that the stars are only a broad indicator, plan sponsors do rely on them at some level. We don't use them ourselves when evaluating mutual funds for pension clients, but I can tell you that every sponsor I've ever talked to at some point or another will bring up Morningstar ratings in some way when talking about mutual funds," said Joseph Valetta, a principal at HR Investment Consultants, Baltimore.
"I think the importance of the Morningstar ratings for mutual funds increases as you go downmarket to smaller plans and among less sophisticated plan sponsors," said David Master, managing director of the Optima Group Inc., Fairfield, Conn. "Among smaller plans, those ratings become increasingly important as an external validator of mutual funds. Most important to a lot of defined contribution plan sponsors is name-brand recognition, then the presentation of the information about the manager and the fund itself. But after that, one of the most important factors is the Morningstar rating. Anything that creates a badge of distinction and an honor roll will influence sponsors and retail investors. There's a point at which Morningstar's rating is the deciding factor."
Mr. Master also said the "badge of distinction" will make it easier for wholesalers to pitch international fund offerings to brokers because of the increase in the star "comfort factor."
Morningstar spokesman Michael Van Dam said Morningstar will separate international equity funds into a fifth broad rating category, split off from equity funds, and join taxable bond, tax-free bond and hybrid rating categories.
"International equity funds have been unfairly punished by the star rating system in the past because they have been compared to all equity funds," he said.
Mr. Van Dam said the same calculations Morningstar uses now for star rating criteria will be used for the international equity funds, but such funds now will be ranked only against their peer group.
Mr. Van Dam would not release information about the criteria used for classifying a mutual fund as international.
He said Morningstar uses the fund's own self-classification for determining international funds, but the system was "currently under debate."
(The chart accompanying this story uses data from Morningstar and shows international and global equity funds with four- and three-star ratings that had least 80% of holdings invested in international stocks as of Sept. 30. No funds meeting the criteria had a five-star rating.)
Mr. Norwitz and others speculated Morningstar would use some minimum investment in international equities as the criteria for classification as an overseas fund. Morningstar officials declined to comment on what criteria would be used for evaluating global equity funds.
While few people are surprised by the news, some observers said Morningstar should go further.
"International equity is not even an asset class anymore in itself, according to Optima's Mr. Master. "There are so many investment style variations and country and sector cuts within the international investment arena, that there's a lot of room for asset class differentiation. This one large rating category is still not providing investors with an adequate means of comparison, though it is better than what they give now."
Rival mutual fund research companies and many consultants said Morningstar would provide a more meaningful rating service if categories were narrower so funds were compared more closely with true peers.
"We are very much of the belief that if you're going to compare funds, you need to compare apple with apples," said Ed Loughlin, president of SEI Asset Management Group, Wayne, Pa. "We'd encourage them to be as style specific as possible in their star ratings.
"Without a greater emphasis on style purity, the stars are leading investors to make erroneous comparisons and perhaps, wrong decisions."
"We've been pointing at the Morningstar system and saying that it's flawed for some time," said Jon Teall, a spokesman for Lipper Analytical Services Inc., New York.
"By changing it, they're reinforcing that it is flawed. It's amazing to us, for example, the way a fund can overnight go from a three-star to a five-star ranking, because Morningstar changed some definition. Our research shows that some of the funds that are rated as five-star funds tend to underperform their benchmark and peers," he added.
Rather than rating funds, Lipper's mutual fund research ranks funds on the basis of straight performance and compares funds to their peers in fairly narrowly defined asset class categories, Mr. Teall said.
