Morningstar rating systems questioned

The era of investors paying a “full load” to buy Class A shares of mutual funds is over.

For at least the last decade, investors in retirement plans who use Class A share mutual funds typically have been able to invest at net asset value, thereby avoiding the payment of any upfront sales charge.

During the past several years, there has also been a persistent — and I suspect permanent — move in taxable accounts toward the use of wrap or fee-based programs that use Class A shares at NAV when they use Class A shares at all. Mutual fund industry experts have estimated that as much as 80% to 85% of Class A share purchases are at NAV.

It is time that Morningstar Inc. of Chicago recognized this trend. The firm’s traditional “star” rating assumes that every investor who purchases Class A shares of a load fund pays 100% of the maximum sales charge.

To Morningstar’s credit, it introduced a load-waived rating for Class A shares in December 2005. At the time of its introduction, the company acknowledged: “In recent years, more investors have qualified for a waived front load, and so Morningstar created this rating to illustrate that distinct investor experience.”

The problem is that the two rating systems are backward. In order to serve a majority of the investing public better, the formula for the star rating should be amended to exclude the sales charge component, and the load-waived rating should be converted to a “fully loaded” rating.

This issue is of particular importance in two areas: the retirement plan market and fee-based broker-dealer platforms. Plan sponsors, consultants and financial advisers often use the Morningstar rating as a screen when selecting mutual funds for a 401(k) plan or for a client allocation in their broker-dealer’s fee-based wrap program.

In many instances, the people doing the screening limit choices to funds with a four- or five-star rating. Because a majority of front-end-load funds waive sales charges both for retirement plans of a certain size and broker-dealer fee-based platforms, the use of the star rating in either of the above scenarios can be misleading.

Furthermore, in many instances, load funds are being offered in both these situations alongside no-load funds, which might receive a higher rating despite poorer risk-adjusted performance, simply because they don’t have a front-end sales charge.

If Morningstar wants to provide information that serves the majority of investors and helps them make informed decisions about mutual fund investing, the time has come for the traditional star rating methodology to be adjusted to reflect the realities of the marketplace.

The Morningstar rating would better serve the vast majority of investors if the front-end sales charge were eliminated from the formula/methodology. For the minority of investors who do pay a sales charge, the load-waived rating should be converted to a fully loaded rating.

Keith Hartstein is president and chief executive of John Hancock Funds LLC in Boston.