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With much fanfare, Morningstar introduced a new fund grading system in November, and so far the results have not been inspiring. During the first quarter of this year, top-rated large-cap blend and mid-cap value funds trailed category averages by half a percentage point. Top-rated small-cap blend funds lagged by 2 percentage points. While it is too soon to draw firm conclusions about the new system, the early returns should serve as a warning for advisors that Morningstar's recommendations may sometimes miss the mark.
Under the new system, recommended funds can win rankings of gold, silver or bronze. Many advisors may be inclined to ignore the whole thing, but that will be hard to do. Funds can advertise that they have won gold, and soon clients will begin asking why they should hold anything that is rated only silver or bronze.
Though the new awards are likely to become the most prominent grades issued by Morningstar, the old star system is not being eliminated. So now funds will carry two grades. Many top funds will be rated as gold and be awarded 5 stars, the highest ranking under the old system. But the two ratings systems do not always agree. In some instances, 2-star funds are rated gold. Such mixed grades are bound to leave advisors and clients scratching their heads.
The grades can vary because the two Morningstar systems use different criteria. The stars are based strictly on past performance. Funds receive five stars when they land in...