The brand that has emerged as dominant in the 1990s is not Fidelity, Putnam, or even Merrill Lynch-but instead is Morningstar.[/:Author:] —R. Pozen, The Mutual Fund Business, 1998, p.75
Perhaps the most popular approach to selecting mutual funds is to rely on the very popular rating service provided by Morningstar that rates funds using a star system similar to the one used by film critics. Ads touting four- and five-star ratings are to be found everywhere. Investors must believe the stars have predictive value. One study covering the period January through August 1995 found that an amazing 97% of fund inflows went into four- and five-star funds, while three-star funds experienced outflows.1
An August 2001 study, by Diane Del Guerico and Paula A. Tkac of the Federal Reserve Bank of Atlanta, investigated how changes in Morningstar's ratings influence mutual fund cash flows. The study, "Star Power: The Effect of Morningstar Ratings on Mutual Fund Flows," covered almost 3,400 domestic equity mutual funds for the period November 1996 to October 1999, and identified over 12,000 ratings changes. The following is a summary of the key findings.
- The initiation of a 5-star rating results in average inflow over the next six months that is 53% greater than the normal inflow.
- An upgrade from 4- to 5-stars increases the rate of inflows over the next six months by 35%.
- Even upgrades from 2- to 3-stars, and from 3- to 4-stars, generates positive abnormal inflows.
- A downgrade from 5- to 4-star has a negative impact, though to a much lesser degree. Fund inflows fell from their norm by 8%. One reason for the smaller impact of a downgrade is that existing investors might be reluctant to sell as capital gains taxes are likely to be incurred as a result of a sale. Another reason is that a 5-star fund that is on a recommended list might not be removed from that list unless the fund continues to lag in performance.
- Downgrades from 3- to 2-stars and 4- to 3- stars also generate abnormal negative flow.
- The influence of ratings changes is observable virtually instantaneously - demonstrating the investors are paying close attention to the ratings, and placing a high value on their predictive ability.
The authors also noted that funds are "more likely to advertise if they have a have a 5-star rating to tout," and advertising impacts fund flows. The paper cited a study that found that funds that advertise in popular magazines such as Barron's or Money receive significantly greater inflows than a control sample of funds with similar performance.2 Funds, of course, are only likely to advertise 4- or 5-star ratings.
For investors the essential question is whether or not chasing ratings is the winning strategy. Let's examine the evidence.
Morningstar gives the coveted five-star rating to the funds it believes is among the top 10% of all funds, and a one-star rating to the bottom 10%. Mark Hulbert's The Hulbert Financial Digest tracked the performance of the five-star funds for the period 1993-2000. For that eight-year period the total return (pretax) on Morningstar's top-rated U.S. funds averaged +106%. This compared to a total return of +222% for the total stock market, as measured by the Wilshire 5000 Equity Index. Hulbert also found that the top-rated funds, while achieving less than 50% of the market's return, carried a relative risk (measured by standard deviation) that was 26% greater than that of the market. If the performance had been measured on an after-tax basis, the tax inefficiency of actively managed funds relative to a passive index fund would have made the comparison significantly worse.3
A Financial Research Corp. study covering the period January 1, 1995-September 30, 1998 revealed that two- and three-star funds outperformed their four- and five-star counterparts for the entire period. The study's conclusion: "the linkage between past performance and future realizations is tenuous if not nonexistent."4
A similar study, by Christopher R. Blake, associate professor of finance at Fordham University's Graduate School of Business, and Matthew Morey, assistant professor of finance at Fordham, found that for the five-year period ending December 31, 1997, the average five-star fund underperformed the market by almost 4% per annum. The study also found that the differences between the performances of the three-, four-, and five-star funds are so small as to have very little statistical significance.5
Blake and Morey concluded that while a low star rating was actually a good predictor of relatively poor future performance, high star ratings were not good predictors of future top performance. The top rated funds did not outperform the next highest or even median ranked funds.6 Morningstar has even stated that there is no connection between past and future performance and stars, historic star ratings, or any raw data, and that the stars should not be used to predict short-term returns or to time fund purchases.7 Despite this strong admission, it is obvious from the heavy expenditures of advertising dollars by mutual funds that they believe investors perceive the star ratings as having predictive value.
Morningstar's ratings are so popular that there have been many studies on their ratings of funds and future performance. One of these, The Persistence of Morningstar Ratings, sought to determine if there was any useful information contained in the star ratings.8 If there is persistence in fund ratings it would be valuable information. Unfortunately, the authors concluded, after studying variable annuities, equity funds, and bond funds, that there is little evidence of persistence of performance. The study found:
- For four-and five-star equity funds, year-to-year persistence is the equivalent of a coin flip. Less than half of all mutual funds rated four or five-star at year end 1997 still held that high rating at year end 1998. Basically, there is a reversion to a 3-star mean.
- Persistence for variable annuities is worse than a flip of the coin. Year-to-year persistence is only about 40%.
- Persistence is the worst for taxable bond funds at just over 20%.
- For equity funds with just 3-year ratings the year-to-year persistence of ratings was less than 25%. Keep this in mind when you think you have discovered a new guru.
You can avoid the mistake of relying on either Morningstar's rating system or the past performance of actively managed funds in general as a way to select the building blocks for your portfolio by remembering the evidence presented here and by listening carefully to the following comments from Morningstar's Director of Research, John Rekenthaler, a man for whom I have the highest regard, especially for his integrity in an industry not especially known for it.
- There's actually not much difference between mid-ranked funds and top-rated ones. Three-star, four-star and five-star funds have been found to perform pretty much alike.9 (In the interests of full disclosure, Rekenthaler did go on to point out that mid-rank and high rank funds do better on average than the lower rank funds. This is a similar finding to the results found by Blake and Morey. However, the persistency of poor performance of low rank funds is most likely a function of their high expenses, and not poor stock selection skills.)
- We should have more answers. There is surprisingly little that we can say for sure about how to find top-notch stock funds.10
- And, commenting on whether investors should pay attention to mutual fund advertisements: …to be fair, I don't think that you'd want to pay much attention to Morningstar's star ratings either.11
Finally, listen to the words of Amy Arnott, the editor of Morningstar's publication. "Over the years, Morningstar's star system has been frequently - and sometimes willfully - misunderstood. Many commentators insist on treating the star rating as a predictive measure or a short-term trading signal. The rating, which is clearly labeled as a historical profile, does neither."12
- Christopher R. Blake and Matthew R. Morey, "Morningstar Ratings and Mutual Fund Performance," Journal of Financial and Quantitative Analysis, September 2000.
- Prem C. Jain and Joanna Shuang Wu, 2000, "Truth in Mutual Fund Advertising: Evidence on Future Performance and Fund Flows," Journal of Finance 55, 937-
- John Bogle, "The Stock Market Universe-Stars, Comets, and the Sun," speech before the Financial Analysts of Philadelphia, February 15, 2001.
- InvestmentNews, March 29, 1999.
- New York Times, April 4, 1999.
- Christopher R. Blake and Matthew R. Morey, "Morningstar Ratings and Mutual Fund Performance," Journal of Financial and Quantitative Analysis, September 2000
- Investment Advisor, September 1994
- Journal of Financial Planning, September 2000.
- St. Louis Post-Dispatch, November 10, 2000.
- Wall Street Journal, December 22, 1998.
- In the Vanguard, Autumn 2000.
- Amy C. Arnott, Editor, Beyond the Stars: The New Category Rating, Morningstar Mutual Funds, Summary Section, Dec. 6, 1996, vol. 29, issue 2.
Larry Swedroe is the author of "What Wall Street Doesn't Want You to Know" and "The Only Guide To A Winning Investment Strategy You Will Ever Need." He is also the Director of Research for and a Principal of Buckingham Asset Management, Inc. in St. Louis, Missouri. However, his opinions and comments expressed within this column are his own, and may not accurately reflect those of Buckingham Asset Management.