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Dancing Around the (Morning)Stars

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You may have caught wind of the recent feud between the Wall Street Journal and Morningstar over an exposé piece in the Journal questioning the usefulness of Morningstar’s star rating system.

Not to be outdone, Morningstar slammed the Journal’s research methodology in its own article, along with letters from two top executives, and claimed the WSJ writers fundamentally misunderstood the star system’s intended use. The two industry heavyweights traded several more rhetorical blows over the following days. But aside from its entertainment value for those of us in the industry, this saga contains some timeless lessons for advisors and investors.

Don’t Be an Unintentional Momentum Investor

Advisors who screen only for funds with 5 stars have typically already missed most of the strong relative returns that put the fund ahead of its category peers in the first place. It’s a form of momentum investing — buy what’s done well recently in the hopes that it keeps doing well.

We’ve also seen more than a few advisors fall victim to the mistake of selling a fund just because it drops to 3 stars (or 4). They know Morningstar is one of the first places their clients will go to research the funds in their portfolio, and it’s easier to convince clients of the merits of buying highly rated funds and selling low-rated funds than it is to defend a fund that has performed well in the long run but whose style is temporarily out of favor.

Screening for highly rated funds is not an inherently bad practice, and Morningstar itself says the star rating system is designed simply to “tilt the odds” in investors’ favor and serve as a starting point for research, not be an end-all metric. But is the tilt really all that meaningful?

You’re Not the Casino

In defense of the firm’s “tilting the odds” position on its star ratings, Morningstar managing director Don Phillips made the point that “dismissal of small advantages is precisely the human dynamic that casinos and many financial services companies use to exploit their customers.”  It’s true that in aggregate, 5-star funds tend to slightly outperform those with 4 stars, which slightly outperform those with 3 stars, and so on.  

Source: Morningstar Inc.

But in an annual event study Morningstar designed to represent the experience of a typical investor in U.S. equity funds of different star ratings using data from 2003 to 2015, it concluded that 5-star funds only outperformed 1-star funds by a cumulative 1.31% on average (35.17% vs. 33.86%) over monthly rolling 5-year periods.

That’s akin to the odds of a pass line bet at the craps table, where the house only has a 1.4% edge. It’s a meaningful advantage if you’re the house and playing thousands of rounds in a night, or if your choice is between two baskets containing every 5-star fund and every 1-star fund. If you’re just a visitor to the casino, though, or an advisor trying to pick a handful of promising funds for your clients, it’s essentially even money.

A Better Way

There are better measures than star ratings to evaluate a fund. Of course, it makes a difference what type of strategy you’re looking for. If you’re looking for an index fund, cost is paramount. But if you’re looking for an actively managed fund, is cost really the most important metric? 

Rather than start with short-term performance (Morningstar rating) or cost, consider whether the manager has proven him or herself through different market cycles and has had the guts to look markedly different from the benchmarks despite the career risk of doing so. Maybe go back as far as 15-20 years or look at metrics like Sharpe ratio and active share that attempt to quantify these manager traits?

While there is obviously no guarantee, past performance can be indicative of future performance — if, and only if, the underlying reason for the performance is repeatable, backed by a consistent process, and viewed in the context of a full market cycle.

Star ratings are not useless, nor are they a mirage as the WSJ article’s title suggests. But before you invest in a fund, know the why behind the manager’s performance and under what market conditions the fund wouldn’t perform as well, so that you can have conviction during the periods when the fund’s strategy inevitably goes out of favor.


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