Don’t Put Too Much Stock In Morningstar Ratings [Vanguard Total Bond Market ETF, PIMCO ETF Trust]

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October 9, 2014 4:26pm NYSE:BND NYSE:BOND

morningstarDavid Fabian: The fallout from Bill Gross leaving PIMCO for Janus Capital Group has continued to spread through the financial community and ultimately generated a review from Morningstar of their flagship fund’s rating.

The PIMCO Total Return Fund (PTTRX) has been downgraded from a gold rating to bronze based on the departure of the company’s CIO and recent outflows suggesting investors are losing patience with recent performance. You can read the full recap here.

While the author makes some sound points regarding the changing of the guard at PIMCO and uncertainty regarding the future outlook for this fund, I find the overall rating structure confusing at best. In addition, the timing of this change seems more in line with generating headlines for Morningstar rather than giving investors insightful and forward thinking guidance for owning the Total Return strategy.

Morningstar currently uses a combination of stars and precious metals badges to indicate a mutual fund’s worthiness for an investors’ portfolio. In the case of PTTRX, it currently has 4 out of 5 stars and a bronze rating. The goal of this system is to compare a particular fund against its peers with similar investment mandates and objectives. This includes performance track record, fees, portfolio makeup, and manager process.

The star rating is based strictly on past performance versus a fund’s peer group. However, the analyst rating can is based on qualitative factors that Morningstar’s team believes will impact future returns. This can ultimately lead to a conflicting situation where a fund’s historical performance is listed on the low side, while their analyst outlook is rated as very bright. That certainly doesn’t lend itself well to an unbiased ranking system that filters the top funds regardless of short-term changes.

As a complimentary example, the DoubleLine Total Return Bond Fund (DBLTX) currently has a 5-star designation with a secondary label as “not ratable” by Morningstar. That seems murky at best despite Jeffrey Gundlach’s reputation as a sound fixed-income manager. I have owned this fund in my own account for years and found it to be an excellent performer relative to other actively managed bond funds.

In my opinion, they should switch to a single rating system that incorporates all of their analysis characteristics across an entire group of funds. This would allow for a clear and concise way to rank each fund in the category based on their individual merits. Expanding their total star count from 5 to 10 may allow for an easier way to accomplish this task and separate a condensed cluster of funds in the middle. That way you don’t end up with a “Yelp effect” of nearly every fund having a 3 or 4 star rating.

Lastly, I take issue with Morningstar finally deciding to make a change to their rating of PIMCO Total Return based solely on this single event.The fund itself has noted 16 straight months of outflows with ongoing battles between management being widely publicized. It would have certainly helped to review this situation on a more regular basis and make recommendations based on proactive rather than reactive analysis.

These factors should be taken into account for individual investors or advisers that overwhelmingly use Morningstar ratings as a buy or sell guidepost.   I still believe that they have some merit with regards to comparing performance and fees of comparable funds. However, you should be careful to do your own due diligence when it comes to understanding an active manager’s track record, outlook, and portfolio construction techniques.

In addition, it’s worth comparing these actively managed mutual funds to passively managed ETFs to ensure they are earning their higher fees or risk adverse qualities. The Vanguard Total Bond Market ETF (BND) is a solid benchmark from which to compare the PIMCO or Doubleline examples used above.

Keep in mind that conditions will change over time and regular monitoring of the health of your portfolio holdings will enhance your chances for success.

This article is brought to you courtesy of David Fabian from FMD Capital Management.

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