Finance experts still debating Morningstar fund ratings

Months after a journalistic investigation called it into question, the scoring system still draws ire

Finance experts still debating Morningstar fund ratings

Last October, the Wall Street Journal published a report with a simple point: funds with star power don’t have staying power. It reached that conclusion based on an analysis of five-star funds rated by Morningstar, which found that only 12% managed to keep their standing after five years. What’s more, 10% of five-star picks fell to just one star over that same period.

Fund investors should already know this, since all fund prospectuses indicate that past results are not indicative of future returns. But Morningstar ratings command a lot of mass investors’ decisions despite being purely based on past results, argues US-based Gordon College professor Alexander Lowry, making them “absolutely overrated.”

“If a fund isn’t four-star or five-star rated then it might as well be dead in the water,” he told InsuranceNewsNet. “Funds follow Morningstar ratings, for better for worse.”

Daniel Kern, chief investment officer at TFC Financial in Boston, offered more tempered criticism. While Morningstar ratings could reinforce a recency bias among investors, low performance tends to persist more than high performance, meaning the ratings could be helpful in identifying the funds to avoid.

“Most novice investors are far better off using Morningstar than not,” added Jonathan Maula, investment manager at Castle Hill Capital in York, Pa. “Doing so will directly lead them to low-cost, better-performing funds more often than not.”

And that could very well include funds from the firm itself. In March last year, Morningstar announced its intention to launch its own line of mutual funds. To Maula, that could introduce a new dimension of conflict as they rate competing funds.

Even opting out of the Morningstar fund-marketing system could have repercussions, according to Peter Kerwin, a communications specialist at the University of Wisconsin School of Business who was also formerly involved with Rhode Island’s 529 college savings plan.

“I was the chief of program development for the Rhode Island Higher Education Assistance Authority and I worked closely with the Rhode Island Treasurer’s office,” he said.

After successfully navigating the 2008 financial crisis, Kerwin said the 529 plan was in the top third/middle range of all programs across the US. But in 2010, it became the worst plan in the country; that was when Alliance Bernstein, the plan’s program manager, stopped paying for licensing agreements that allowed them to run Morningstar rating information in their marketing.

“It seemed pretty clear to me we were getting whacked for that decision, so I started digging into their ratings methodology and I found it was pretty much a disaster,” Kerwin told InsuranceNewsNet. He explained that Morningstar measured plan performance based on five general categories, but claimed that they could assign different weights to findings in those categories.

“It was an opaque set of standards that allowed them to put their finger on the scale and reward or punish plans at will,” he said.


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