Check the Handicaps of the Morningstar-Rated Funds

Dr. Ali Hirsa, Satyan MalhotraAdvisor Perspectives welcomes guest contributions. The views presented here do not necessarily represent those of Advisor Perspectives.

You may be able to add up to 200 basis points of excess returni when a fund’s handicaps are applied as supplemental assessment to Morningstar gold-rated funds.

Fund selection is a complex process. Beyond the suitability aspectsii, there are hundreds of proposed performance measures, third-party metrics, analytical process and due diligence discussions to assess funds. Among them, Morningstar ratings are quite popular as an analytical metric. Given Morningstar’s reputation, even if we assume that they look at all the traditional and some proprietary measures in rating mutual funds, we are still left with more than a handful of similarly rated funds for each asset class. For example, if we use the forward-looking medalist ratings, there are several gold-rated funds from which to choose. If Morningstar ratings are a filtering criterion, how do you incrementally assess all the gold-rated funds?

We propose fund Handicaps as a supplemental assessment datapoint.

As background, in our May 22nd Advisor Perspectives article, we introduced the Advisor Assessment Framework with its three-core metrics:

  • Score – shorter-period performance path profile relative to the benchmark, as a risk attitude trend measure;
  • Handicap – average longer-period performance path profile relative to the benchmark, as a stable risk attitude measure; and
  • Fairway average – propensity to take risk relative to the benchmark, as a risk attitude beta measure.

Collectively they provide insights around the asset’s (or advisor-recommended portfolio’s) risk taking as it navigates a benchmark. While the Advisor Assessment measures are meant to complement each other, the final weighting for a measure can depend on the objective.