On July 8^th, Morningstar announced changes to two forward-looking ratings systems that it uses to rate managed investments (e.g., mutual funds).[i]  One of the affected ratings systems is the Morningstar Analyst Rating, which denotes Morningstar’s conviction in a fund’s ability to outperform relevant benchmarks and peer groups.[ii]  Changes to the Analyst Rating include (i) giving greater weight to fees; (ii) setting a higher bar for active funds by requiring them to convince Morningstar’s analysts that they can beat both their benchmarks and the peer groups; and (iii) focusing on the people, process, and parent organization for the fund (e.g., the sponsoring adviser) that Morningstar believes are predictive of fund performance.[iii]

Morningstar has signaled that funds should expect updates to their Analyst Ratings based on the changes, which will go into effect on October 31, 2019.[iv]  We anticipate that the changes will most negatively impact actively managed funds that have underperformed either their benchmarks or their peer groups (those that have underperformed both are already poorly rated) and those that outperform their benchmarks and peer groups while charging higher than average fees.  It is likely that funds falling into these categories have marketed themselves, in part, on their high Morningstar ratings.

Over the next three months, funds, advisers, and fund boards should assess the likely consequences of the announced changes and adjust their marketing strategies accordingly.  As they do so, they should work with legal counsel to ensure any revised marketing materials and accompanying disclosures comply with nuanced marketing rules.

If you have any questions about the changes Morningstar has announced or the marketing rules applicable to mutual funds and their advisers, please feel free to contact us.

By the Investment Management and Broker-Dealer Team at Kilpatrick Townsend & Stockton