A False Star
Morningstar’s iconic star ratings are a bit like a tarot card reading: ineffective at telling the future and largely a waste of time. Yet they remain hugely and persistently popular. Mutual fund managers widely publicize their funds’ star ratings, and many advisors use star ratings as a kind of screening tool when hunting for a new fund. Unfortunately, this is usually misguided. Here are three reasons why advisors should jettison star ratings from their process.
Morningstar is conflicted. Like the big three credit rating agencies, Morningstar is paid by the people it claims to be impartially evaluating. In this case, that means the mutual fund companies. As a result, Morningstar has a direct incentive to make mutual fund managers look better than they deserve. This is reflected in the design of the star rating system itself. Stars are assigned based on ranking versus other funds, not a benchmark index. This avoids questions of whether or not the fund managers generate any value and means that it’s theoretically possible for funds to receive five stars without ever beating their benchmark. Hmmm…. Additionally, Morningstar’s system seems designed to be especially forgiving to mediocre performers. Morningstar’s methodology results in almost 70% of funds being given ratings that are average or above average. It’s a bit like one of those “everyone gets a trophy” situations.
The star system isn’t designed to predict future outperformance. You read that right. Morningstar doesn’t even claim to have predicting out-performance in mind as an objective. Not only that, but they go further to state that “a high ranking does not [even] imply approval or an endorsement”. That will come as a surprise to 99% of the public who assume star ratings are precisely those things. The reality, as Morningstar occasionally reminds people, is that the star system is simply (and only) a representation of historical risk-adjusted return for a fund, relative to similar mutual funds. As a basis for selecting a mutual fund, it’s backward looking, and overly narrow.
As a predictive tool, star ratings are demonstrably ineffective. Perhaps it’s not surprising that a tool that doesn’t attempt to predict performance should fail to do so. After all, an unaimed arrow rarely finds the bullseye. Nevertheless, Morningstar (and others) periodically look at how well the star ratings predict performance because they know that implying good future performance is the only possible application for the rating system. The results are pretty clear. At the margin, they find that higher rated funds have a slightly better than random chance of outperforming peers. Yet, this is widely understood to be almost entirely the result of fee-differentials amongst funds. More expensive funds underperform less expensive ones, all else being equal.
Perhaps all of this seems too much like shooting fish in a barrel. Maybe it’s unfair to criticize Morningstar when they’ve been relatively upfront about how their ratings system works. And none of this is meant to impugn their much more valuable qualitative gold/silver/bronze fund assessments (known as Analyst Ratings). But at the end of the day, this rating system deserves to be widely panned. Both Morningstar and the mutual fund companies that pay Morningstar are complicit in using star ratings as a bogus and misleading marketing technique. This is the kind of subtle artifice that gives everyone in finance a bad rap. Morningstar should stick to providing data, and ditch the stars. We don’t think anyone except the mutual fund companies will mourn their absence.
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The information and opinions expressed herein are for general information and educational purposes, and may change at any time. They do not constitute investment advice and are not a solicitation for the purchase or sale of any security or implementation of any specific investment strategy.