Advisors and investors have been sharing their mutual fund decision-making process and factors with us for years. As a market researcher in financial services, I can tell you that while Morningstar fund ratings don’t always make it to the top of the stated list immediately, they are regularly referenced, and advisors note that the ratings are a rare data point that seems to resonate with clients. The ratings also often capture attention when marketing material is tested. This is especially true when the material is for a brand not already at the top of an individual’s consideration set. And, for every time an advisor admits that the ratings have some impact, there are other times when the impact is understated or even unknown to the advisor.
Given the role of these ratings, the story on the front page of The Wall Street Journal today, “Mutual-Fund Ratings Are Not What They Seem,” is rather explosive. And, of course, the idea that “five-star funds eventually turn into merely ordinary performers” is particularly interesting to a researcher who regularly assesses correlation and reversion to the mean. The conclusion from TWSJ’s analysis is that five-star Morningstar ratings have little to no relationship to future performance, even though many in the industry attempt to use them in a predictive way. This leads to my own conclusion: of course! Say it together now: past performance is no guarantee of future results.
In the world of fast-paced global news and a vast array of mutual funds, advisors and investors alike look for ways of quickly zeroing in on a good enough product. The Morningstar fund ratings are an easy way to do this. The article itself quotes Joe Mansueto, founder of Morningstar, as saying, “It’s a way to whittle down a big universe into something more manageable.” It also rightfully points out that the problem is not in the ratings themselves, which are arguably a substantial improvement in transparency over the pre-Morningstar time, but in how the ratings are used. Morningstar has an imperative to be nothing short of completely clear in what its ratings do and do not represent, and there are opportunities for it to tighten up its communication here. However, I suspect that Morningstar could buy all of the advertising real estate in Times Square to explain this point, and it would barely move the needle on how advisors and investors behave.
Advisors lament the fact that clients pay acute attention to the S&P 500 and DJIA as indicators of how their portfolios should perform, even though those portfolios are much more heavily diversified. But that’s the reality, and so advisors have no choice but to keep a close eye on these as benchmarks. The same will apply here. Additionally, there is an element of the old adage, “you don’t get fired for choosing IBM.” Even if the five-star rating doesn’t ultimately translate into better performance, barring a better replacement, it will still feel safer to suggest five-star funds.
TWSJ’s article appears well researched and is well written. And I expect it to be ignored.