Morningstar Continues Rollout of Analyst Mutual Fund Ratings, Only 7% Negative.

Morningstar has been rolling out it's new "forward looking" analyst ratings for mutual funds since last November as I have touched on before. The number of funds rated has gone from 349 funds to 924 as of the end of the 2nd quarter (You can see the full list as of 6/30/12 here). While it has been good to see the distribution of ratings even out somewhat, Morningstar still appears to have an allergic reaction to rating funds "negative" as can be seen below.

As a reminder about the meaning of the ratings, per Morningstar....

"The Analyst Rating is based on the analyst's conviction in the fund's ability to outperform its peer group and/or relevant benchmark on a risk-adjusted basis over the long term. If a fund receives a positive rating of Gold, Silver, or Bronze, it means Morningstar analysts think highly of the fund and expect it to outperform over a full market cycle of at least five years."

After reading that you might assume that anything rated gold, silver or bronze is a fund Morningstar analysts think will provide risk-adjusted outperformance compared to a relevant benchmark over a full market cycle of atleast 5 years. Apparently not......as can be seen by the majority of ratings given to 29 index funds. Obviously you could not expect an index fund to outperform it's relevant benchmark....after all, index funds are designed to REPLICATE their relevant benchmark. So they should generally perform in line with the benchmark, minus fees. The best an index fund can hope to do is meet Morningstar's definition of neutral "Fund that isn’t likely to deliver standout returns, but also isn’t likely to significantly underperform".

Despite the fact that by their very nature index funds can't be expected to outperform their relevant benchmark, of the 29 index funds Morningstar rated, the ratings breakdown as follows: 14 Gold, 9 Silver, 3 Bronze, 2 Neutral, 1 Negative. It is true that the majority of actively managed mutual funds underperform their benchmarks as can be seen below (you can see more in S&P's Indicies vs Active Report). However, the reality is index funds always underperform their benchmarks! (unless a sampling error works in their favor).

However, what Morningstar should take away from the above info is not that index funds deserve metal ratings, what they should take away is that they need to be much more stingy in giving away Gold, Silver & Bronze....because the majority of mutual funds, ACTIVE & PASSIVE, underperform their benchmarks! If everyone knew that metal ratings only meant they would perform like their benchmark I doubt anyone would care for that information, yet Morningstar thinks that is exactly what they should do.