Morningstar debuted its new mutual fund ratings systems this week.
Everyone’s known for some time that the company’s widely used star system for ratings doesn’t work to predict future results any better than simply using funds’ expense ratios. Morningstar itself acknowledged the fact that expense ratios are a better predictor of performance.
Even after that evidence, however, the Chicago-based company continued to use the stars, which are a signature of the company’s brand. Mutual funds continued to use the stars to advertise. And harried investors, unfortunately, still make many investing decisions based on them.
As The Wall Street Journal reported when it wrote about the new system,
We still get calls that say, ‘Hey, why haven’t you gotten me out of this two-star fund?'” said Tim Courtney, chief investment officer of Oklahoma City-based wealth manager Burns Advisory Group Corp.
Mr. Courtney said there was a widespread misperception among investors that the star ratings were meant to indicate a fund’s quality, and that he hopes the new system will help change that.
The new system, which grants funds a gold, silver, bronze, neutral or negative ranking, is based “in part on past performance, but also employs other quantitative and qualitative measures including the fund’s expense ratio, Morningstar’s perception of the fund manager, the fund’s parent company and the fund’s investment strategy,” said The Wall Street Journal.
Morningstar admitted that its star system was not as good a predictor as expense ratios last year, winning praise from the media. Tara Siegal Bernard of The New York Times called the company’s acknowledgement “an act of radical transparency.” Isn’t that sort of like praising members of Congress for being extraordinarily transparent because they file reports on their insider trading … while they continue to do it?
As far back as 1999, academics had concluded Morningstar’s star system was marginally valuable, at best. Christopher R. Blake and Matthew R. Morey of Fordham University wrote that:
First, low ratings from Morningstar generally indicate relatively poor future performance. Second, for the most part, there is little statistical evidence that Morningstar’s highest-rated funds outperform the next-to-highest and median-rated funds. Third, Morningstar ratings, at best, do only slightly better than the alternative predictors in terms of predicting future fund performance.
The question now for investors is whether to pay attention to the new ranking system (or keep paying attention to the old one). Why, given the company’s track record, would an investor do that?
About the author(s)
Journalist Elizabeth MacBride is Wealthfront's editor. Her work has appeared in Crain's New York, Advertising Age, the Washington Post and the Christian Science Monitor, among other publications. View all posts by Elizabeth MacBride