Advisers: Morningstar's star ratings not much use, but clients love them

Professionals say the WSJ article's point isn't exactly new, but that fund companies might be misleading investors by using the ratings in ads

Oct 26, 2017 @ 2:07 pm

By John Waggoner

Investment advisers reacted to the Wall Street Journal's attack on Morningstar's star ratings with a single question: Why would you use measures of past performance to choose a mutual fund?

The Journal's piece, The Morningstar Mirage, looked at the performance of thousands of mutual funds dating back to 2003. "A lot of these investors, and the people paid to guide them, take for granted that the number of stars awarded to a mutual fund is a good guide to its future performance," the story said. "By and large, it isn't."

Among its findings: Of funds awarded a five-star ranking – the highest – only 12% performed well enough to earn a five-star rating the next five years. Another 10% landed with a one-star rating, Morningstar's lowest.

Morningstar's response, written by Jeffrey Ptak, Morningstar's head of global manager research, noted that the star rankings are designed to be a report card on fund performance, not a crystal ball. And it disagreed with the Journal's conclusion. "Using the Journal's own findings, which were selectively disclosed in the feature article that ran today, we find that highly rated funds were far more likely to outperform low-rated funds in the future," Mr. Ptak wrote.

Morningstar CEO Kunal Kapoor has alluded to making improvements on Morningstar's rating systems using big data, but the company says no announcements are forthcoming at the moment. Mr. Kapoor was unavailable to comment.

ADVISERS AGREE

By and large, advisers agreed with Morningstar: The star ratings are best as a report card on previous returns, not a prediction of what will come. "WSJ's discrediting of Morningstar star ratings should not have come as a surprise," said Jason Lina, lead adviser, in an e-mail. "We've seen this movie before. In fact, Morningstar has discredited their own star ratings in the past. Consider a 2016 Morningstar white paper which makes bold statements such as 'Over the long term, there is no meaningful relationship between past and future fund performance.'"

And many advisers say they don't use Morningstar's star ratings when evaluating mutual funds. "We do not talk about star ratings with clients," said Geoff Owen, a financial planner with Raymond James. "The presence or absence of stars is not a deciding factor in our comprehensive fund selection process."

While one-star ratings do at least note that a fund's risk-adjusted returns have been lousy the past five years, advisers say they prefer to take a deeper dive into fund performance. "Morningstar ratings are good measure of how funds have done in the past, not a predictor of the future performance of the fund," said a financial planner with Benedict Financial Advisors Inc.

"We would have some concern if a fund is rated below average (one or two stars) and may even have some concern for a fund being a five-star fund. It is our job as advisers to have a good understanding of the fund's strategy and realize a fund that has done exceptionally well in the recent past may be due to an over-weighting to a particular sector or asset class. That weighting could lead to under-performance if that sector/asset class lags going forward."

All of which is not to say that Morningstar gets a pass for how retail investors use the star ratings. "Our clients naturally get fixated on star ratings because that's how they choose movies, hotels, and purchases on Amazon," said Mr. Lina. "Morningstar wisely fulfilled this need for star ratings. In their defense, they didn't go out and say five-star funds are likely to be the best and one-star funds are likely to be the worst. Consumers made that jump."

MISLEADING USAGE

Nor do mutual fund companies, which use Morningstar ratings prominently in advertising, get a pass for using star ratings. "Most fund companies' use of star ratings in promotions can be misleading," said Jon Ulin, managing principal of Ulin & Co. Wealth Management. "While many of the restaurant reviews on Trip Advisor are credible and can influence where you may be having dinner tonight, it would be insane to utilize star-ratings as a primary tool in your investment decision making process."

By Morningstar's own count, $188.3 billion has flowed to five-star funds the past 12 months. In contrast, $133 billion has fled three-star funds, $109.2 billion has left two-star funds, and $18.5 billion has jumped from five-star funds in the same period.

It's not all from lonely retail investors. As much as advisers pooh-pooh Morningstar ratings, at least some of them take the rankings seriously. "The questions I get from advisers are, 'How did you do in the past three and five years, and what are your star ratings," said Steve Graziano, president of Touchstone Investments. "It's better to ask, 'What kind of environment are we headed into, and how have funds performed in that environment?"

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