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The over-hyped battle over star ratings

Chuck JaffeChuck Jaffe ·

The battle between Morningstar Inc. and the Wall Street Journal over the most influential force in the mutual fund business isn’t new and isn’t news, but it has been the talk of the mutual fund industry over the last few weeks.

It started when the Journal published a long “investigative” piece on Oct. 25 about “The Morningstar Mirage,” which claimed that a high percentage of funds that get a top, five-star rating from the Chicago-based research firm don’t maintain their top standing going forward. Meanwhile, those top-rated funds attract the bulk of money flowing into new funds.

The implication was that investors are somehow misled by the system. The reality is far less nefarious.

Morningstar responded with articles from three of its top executives; they repeated the company’s long-held mantra on its famous system, namely that star ratings are a backwards-looking analysis of a fund’s data that should be little more than a “first step” for investors hoping to find a fund with the potential to do moderately well in the future.

For background, it’s important to understand that the star system is a quantitative measure of risk-adjusted fund performance that Morningstar started using in 1985. It tries to determine how a fund’s returns – relative to the risks it takes – measure up. Stars themselves are awarded on a bell curve, with the top 10 percent of funds in a category receiving a five-star rating and the next 22.5 percent getting four stars. The middle 35 percent earns three stars as the curve reverses down to where the bottom 10 percent earns just a single star.

Over the years – as the science of evaluating both funds and data in general has evolved — Morningstar has increasingly discounted stars, typically as it has acknowledged and fixed shortcomings in the system. It first created category ratings in 1996, then de-emphasized stars altogether as it created analyst ratings; those gold-silver-bronze awards – plus neutral and negative ratings – are meant to be predictive, and there are many cases where the star rating and analysts medal disagree, so that a five-star fund might get a bronze from researchers.

   Moreover, Morningstar always has fought against any suggestion that high star ratings were the equivalent of a buy recommendation.

Still, there is no denying where investors put their money.

A wide range of industry studies show that somewhere over 90 percent of money flowing into mutual funds is put into issues graded four- or five-star at the time of purchase. Fund companies pay Morningstar boatloads of money in order to trumpet their high-star funds in advertisements and promotional documents knowing that the ratings system – despite its flaws – is seen as an equivalent to the Good Housekeeping Seal of Approval

The Journal, for its part, either did not know or simply failed to acknowledge that plethora of studies discussing how the performance of top-rated funds generally degrades or regresses to the mean. Those studies date back to at least 1999, and the subject came up over and over before mostly dying out – or being rendered moot – when Morningstar implemented analyst ratings in 2011.

   The Journal report found that five-star funds maintained higher ratings than four-star funds over time, and that four-star funds were able to sustain higher ratings than three-star funds, and so on. Technically, this means that choosing a higher-rated fund did give investors an edge.

It’s not much of an advantage, and there’s no arguing with the idea that the importance of ratings has been overblown by a public that barely understands how they work.

And there is the rub.

It is clear that relying on star ratings as the primary or best way to evaluate funds is wrong-headed. In more than two decades of covering the company, I have never heard anyone from Morningstar suggest anything else. Morningstar’s information page on ratings notes that “A high rating alone is not a sufficient basis for investment decisions.”

That doesn’t stop some investors from wishing – or at least putting too much weight – on stars. (The Journal article suggested that many advisers rely on stars, and are disappointed with the outcome; the vast majority of financial planners I talk with long ago discounted the star system.)

What investors need to know is that divining a way to identify active managers who will outperform the market in the next cycle is virtually impossible. There are studies – most recently work done for the Journal story — suggesting that Morningstar’s analyst ratings have little predictive power; it might be a fair criticism, but since the analyst measures debuted during the current bull market, they haven’t even run a full market cycle yet, so it’s still a bit early to judge them.

Ultimately, the Journal story stirred the pot and got investors talking, but didn’t bring out anything new.

For investors, meanwhile, it’s important to keep star ratings – and any valuation system – in context.

Ratings spurred 1980s and ‘90s investors to diversify; prior to ratings and rankings, fund investors bought a fund or two and left all decisions to the manager. Stars allowed investors to see what funds had done, how they enhanced or overlapped each other, and improved how portfolios were built.

But the fund-selection process starts with the individual asking “What kind of fund(s) do I need?” It proceeds with finding funds that meet those needs plus personal criteria (low-cost, active or passive, available on the fund platform you use, etc.), and only then should independent analysis be factored in to determine which funds can inspire your confidence so that you can buy and hold them long-term, because one thing that kills performance more than picking a mediocre fund is routinely jumping between funds, typically at the worst possible times for the transactions.

If you still can’t decide what to buy at that point, ditch the analysis and let low costs be your guide. That tends to pay off over time more than any selection system, proving again, that the focus in picking funds should be on the fund itself rather than on ratings.

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   Chuck Jaffe is editor at RagingBull.com; he a nationally syndicated financial columnist and the host  of “MoneyLife with Chuck Jaffe” (moneylifeshow.com). He is a long-term investor and does no short-term trading of stocks, options or ETFs. You can reach him at chuck@ragingbull.com.

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