Is the industry relying too much on Morningstar ratings?

A new investigation shows how five-star funds really tend to perform over the long run

Is the industry relying too much on Morningstar ratings?
It’s a nugget of wisdom that’s popular throughout the investment industry: past performance does not guarantee future returns. And that’s true even for top-rated funds.

In an investigation into the performance of thousands of funds rated by Morningstar since 2003, the Wall Street Journal found that highly rated funds attracted the vast majority of investor dollars, but mostly failed to perform over the long term.

“Of funds awarded a coveted five-star overall rating, only 12% did well enough over the next five years to earn a top rating for that period,” the Journal said, adding that 10% declined to a one-star rating.

The figures are concerning given Morningstar’s influence throughout the mutual-fund industry. The firm has said that roughly 250,000 financial advisors rely on its data, services, or ratings. Fund companies advertise heavily based on Morningstar star ratings; funds that earn a five-star rating typically see more money pouring in afterward, and outflows typically ensue for those that lose stars.

The Journal’s analysis found that while most five-star funds perform somewhat better than lower-rated funds, those top-rankers tend to become merely ordinary performers. It also determined that the average performances of the different star categories converged over time.

In defense, Morningstar said its star system is strictly based on assessments of past performance. “We have always been very clear that it’s not intended to predict future performance,” it said in a written statement. The firm went on to say that the star rating is meant to be “a first-stage screen that helps identify lower-cost, lower-risk funds with good long-term performance.”

The firm had previously issued conflicting indications of predictiveness. Morningstar founder Joe Mansueto has said that analyses of past ratings found “modest predictive value,” while CEO Kunal Kapoor has separately called the system “a better predictor than it has ever been.”

Morningstar segments mutual funds into more than 100 categories. The firm rates them based on their performance adjusted for their degree of risk over three years; funds that are old enough are also rated based on five-year and 10-year records. To determine a fund’s overall rating, the firm compares it with others that fall within the same bucket; the top 10% in each group get five stars.

Most investors only see the overall ratings, and tend to rely on them — a fact that some employees at the firm have expressed concern over. “Morningstar’s star ratings for funds are clearly used in the industry to imply that funds that performed well in the past will do so in the future,” Stephen Wendel, Morningstar’s head of behavioral science, said in a recent article for Morningstar magazine. “That needs to change.”

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