According to a Morningstar news release, the new rating system for hedge funds uses a scale of one-to-five stars. Morningstar first categorizes the hedge funds into one of 17 Morningstar Categories, such as “convertible arbitrage” or “emerging market equity,” according to a series of quantitative and qualitative measures. Next, Morningstar ranks and rates the hedge funds against their peers in the Morningstar Categories based on risk-adjusted return, the announcement said.
The risk-adjusted return calculation and rating address two issues that are specific to hedge funds, Morningstar said. First, unlike many other risk-adjusted performance measures, the Morningstar hedge fund rating does not assume that funds have returns that follow the normal bell curve distribution.
Second, the rating addresses the fact that some hedge funds invest in illiquid securities that are infrequently priced. Infrequent pricing gives hedge fund managers “flexibility” in how they value such positions when calculating returns they report to hedge fund databases. The result is a smoother or less volatile reported return series.
To correct for this the company said it applies a statistical procedure to the return series and then calculates the risk-adjusted return measure. This risk-adjusted return measure accounts for all variations in a fund’s monthly performance, with more emphasis on downward variations.
Morningstar’s database has approximately 7,700 direct hedge funds and funds of hedge funds. To qualify for a rating, direct hedge funds must have at least 38 months of consecutive performance data, the news release said.
Funds of hedge funds, of which there are 3,300 in Morningstar’s database, are not eligible to receive ratings. Morningstar expects that approximately 1,800 of the 4,400 direct hedge funds in its database will receive ratings.
Hedge Fund Index
Morningstar also launched the Morningstar 1000 Hedge Fund Index, a global, broadly representative benchmark for hedge fund performance, the company said.
The index is composed of the top 90% of eligible assets in Morningstar’s hedge fund database. For the purposes of the index, Morningstar counts funds with shared portfolios as a single hedge fund; funds of hedge funds are excluded from consideration.
The index is updated daily for the previous month-end, rebalanced monthly, and reconstituted semi-annually. In addition, Morningstar said it has launched 17 category indexes based on Morningstar’s strategy-specific classification system for hedge funds.
“We believe the Morningstar Rating for hedge funds is the best starting point for judging a fund’s past performance. We want to make researching hedge funds a more transparent process and our new ratings and indexes will allow qualified investors, advisers, and institutions to better evaluate and compare hedge funds to their peers,’ said John Rekenthaler, vice president of research, in the announcement.
More information is available at http://global.morningstar.com/hedgefundratings.