Anthony Serhan of Morningstar explains the role, application and value of qualitative ratings as part of the investment and research process.

Date: July 2011

Tags: Research, Ratings

• Qualitative and analysis-driven ratings add value to portfolios when looking at average returns against relevant benchmarks
• Qualitative ratings are not a prediction on the market, or an asset allocation tool, or a credit rating, or a short-term performance call
• Often, people can rely on the ratings too much, without reading the offering document
• Qualitative ratings are more of an aptitude test: what is the likelihood of this manager or fund being successful in the future?

After looking at the success of qualitative and analysis-driven ratings in certain markets, it is clear that they have added value to portfolios, said Anthony Serhan in an interview.

So by looking at the average returns of products for which Morningstar, for example, has had a positive assessment, this has beaten the relevant benchmark.

Misconceptions about qualitative ratings

According to Serhan, it is key that investors and advisers understand what qualitative ratings are not.

For example, he explained, they are not a prediction on the market, or an asset allocation tool. It is possible to have a highly-rated product which invests in securities which are either over- or under-valued.

People should therefore start using these ratings after they have worked out their asset allocation model, what type of risk they are comfortable with, and which markets they want to be in, he advised.

Qualitative ratings then become very useful in selecting the individual securities to invest in.

At the same time, these ratings are not a credit rating, added Serhan. For example, when looking at bond funds, where Morningstar might allocate certain ratings to individual managers, he said this is not a comment on the credit quality of the underlying portfolios.

Also, the ratings are not short-term performance calls, he said. Instead, assessments are made by looking at managers over a three- to five-year investment period.

There are many examples where highly-recommended managers underperform for several years – but then investors get their pay-back when markets turn.

Pitfalls of ratings within decision-making

Often, people can rely on the ratings too much, said Serhan, without reading the offering document. In doing this, they won’t understand the risks of the underlying portfolios.

A rating by itself, therefore, shouldn’t replace the need to do some reading about what the product is and what the risks are.

Best practices in developing a portfolio

To really have a view on the future, Serhan said it is critical to understand what the situation is today. Qualitative ratings are more of an aptitude test: what is the likelihood of this manager or fund being successful in the future?

Some people will use them as a screening tool, he said, whereas others will use it to really build a portfolio from the bottom up.