Investment research house Morningstar has published analyst ratings for more than 250 global exchange-traded funds, including approximately 100 funds listed in the US, accounting for more than $1.7tn in assets as of 30 September 2016.

Ben Johnson, Director of ETF Research, Morningstar.

The Morningstar Analyst Ratings is a qualitative ratings system based on research from Morningstar’s team of fund analysts. Morningstar has approximately 115 manager research analysts worldwide and the company provides data on approximately 13,900 exchange-traded product listings (as of 30 June, 2016).

Morningstar has been using the system for open-ended funds for about five years.

The ratings displays analysts’ conviction in a fund’s ability to outperform its relevant peers on a risk-adjusted basis over a full market cycle. The system follows a five-tiered scale: Gold, Silver, Bronze, Neutral, and Negative, with analysts arriving at a rating through an assessment of five key pillars: process, performance, people, parent, and price.

Ben Johnson, Director of Global ETF Research for Morningstar, writes: “In sum, we reserve our Morningstar Medalist ratings for those low-cost ETFs that we believe will tightly track a sensibly constructed index during a long time frame. We favour ETFs backed by experienced managers and sponsored by firms that are good stewards of investors’ capital. And we do so because we believe these attributes are likeliest to translate to outperformance when compared with a relevant peer group over a market cycle.”

Of the 261 ETFs analysed, Morningstar analysts assigned a Gold rating to 37 ETFs, a Silver rating to 80 ETFs, a Bronze rating to 74 ETFs, a Neutral rating to 68 ETFs, and a Negative rating to two ETFs – globally nearly 75% of the initial ETFs to be analysed under the new ratings system received at least a Bronze medal rating.

According to Morningstar, the funds selected for the initial round of analysis include some of the largest, most popular ETFs globally. These funds mainly represent ‘core-portfolio’ holdings, and may have been able to reduce their fees due to economies of scale. As such, they potentially represent a more favourable sample of the entire ETF demographic. Over 1,500 ETFs are yet to be put through the Morningstar Analyst Ratings system.

In the US, Morningstar analysts assigned a Gold rating to 18 ETFs, a Silver rating to 38 ETFs, a Bronze rating to 35 ETFs, and a Neutral rating to 11 ETFs.

The underlying methodology includes a comparison of risk-adjusted returns and adjustments for fund expenses. This means the more expensive the fund is, the harder it will be for the fund to earn a high star rating. (For a detailed description of the Morningstar Ratings methodology, click here)

Every fund is rated versus its category peers over three discrete periods: three years, five years, and 10 years. Funds are rated on a curve, with the top 10% and bottom 10% of risk-adjusted performers in each category receiving one star and five stars, respectively. The next 22.5% at each end of the scale receive two stars and four stars, respectively, whilst the middle 35% receive three stars.

The final rating is a weighted average of the rating for all three periods. In keeping with the view that funds are long-term investment vehicles, the final rating puts the most emphasis on longer time periods. For a fund with 10 years of history, Morningstar puts 50% of the weight on the 10-year period, 30% on the five-year period, and 20% on the three-year period. For a fund with five years of history, Morningstar puts 60% of the weight on the five-year period and 40% on the three -year period.

By placing emphasis on long-term performance, the methodology helps investors avoid funds with alluring short-term performance but poor long-term records.

While the ratings system provides an easy-to-use, quick comparison between similar funds, investors should be cautious in using the ratings as their sole basis for investment decisions due to certain limitations of the system.

Firstly, a high rating isn’t a guarantee that a fund will be a solid performer. A fund may very well have a 5-star rating because of its impressive historical record, but, as performance-chasers often find out the hard way, the past doesn’t reliably predict future returns.

Secondly, the subjective nature of analyst expectations should always be taken into account. Morningstar notes that analyst ratings are based on current expectations about future events and therefore involve unknown risks and uncertainties that may cause events to differ significantly from Morningstar’s expectations.