Are Morningstar’s ratings a good guide to mutual funds?

A Wall Street Journal article argues that the company's fund ratings have no predictive power.

Stars.

“I enquire now as to the genesis of a philologist and assert the following,” Friedrich Nietzsche wrote (and Donna Tartt quoted). “1. A young man cannot possibly know what Greeks and Romans are. 2. He does not know whether he is suited for finding out about them.” I assert some similar rules about investing:

A mutual fund manager cannot possibly know what stocks will go up. No one else knows whether she is suited for figuring out what stocks will go up.

Those rules are not absolute, but they are a helpful first cut; the first is just the efficient-markets hypothesis, while the second is a straightforward corollary. So for instance you should be very skeptical if someone tells you that Mutual Fund X is better than Mutual Funds Y and Z. How would they know? Perhaps X outperformed Y and Z last year, but last year’s performance provides very little evidence about next year’s.

Morningstar Inc. rates mutual funds, from one to five stars. If you think that those ratings are, or are even intended to be, accurate predictions of which mutual funds will perform well in the future, then you are mostly wrong. Instead, the star ratings are essentially historical: A five-star rating means that a fund has performed well in the recent past. A person who understands the mean-reverting nature of mutual fund investing will not conflate those historical results with a prediction about future performance. A person who just sees a five-star rating, though, might get confused. A five-star rating is good, right? You want funds with good ratings, right?

Here’s a big Wall Street Journal story titled “The Morningstar Mirage,” about how Morningstar star ratings are not especially predictive. Not to take anything away from the Journal’s analysis, but to me the news here was mostly that people thought they were predictive. Perhaps I have spent too long marinating in the efficient-markets hypothesis, but I just assume that nothing is predictive of anything, an attitude that has served me well in life. But of course the main use of a Morningstar five-star rating is to go into mutual-fund advertisements, and I suppose it is intuitive to see all those stars and think that they are predictive.

Inside Morningstar, some employees have expressed discomfort about how much investors rely on the ratings. Stephen Wendel, head of behavioral science at the Chicago-based firm, wrote in the June/July issue of Morningstar magazine that part of his job was “examining whether we are contributing to abuses in the industry,” and said: “Morningstar’s star ratings for funds are clearly used in the industry to imply that funds that performed well in the past will do so in the future.”

He added, “That needs to change.”

Morningstar responded critically to the Journal article, making two basic points:

Morningstar does not “sit idly by while investors and advisors misuse the star rating as if it was predictive,” but instead educates the market to understand that the star ratings are not predictive but are just a first-cut tool to understand the mutual-fund universe; and also the star ratings are predictive.

Really! And the thing is, they’re not wrong: “The Journal’s own analysis,” they say, “found that 5-star funds outperform 4-star funds which outperform 3-star funds which outperform 2-star funds which beat 1-star funds.” The Journal found that five-star funds tend, over the 10 years after getting that rating, to get an average rating of three stars. Four-star funds end up with an average rating of 2.8 stars. One-star funds end up at 1.9. Three stars isn’t five stars, but it isn’t 1.9 stars either. Everyone ends up average-ish — “Reversion to the mean is a powerful force that can affect any investment vehicle,” Morningstar told the Journal — but the five-star funds end up more average than the one-star ones. The stars do have some predictive power.

I am not sure I would have guessed that? S&P Dow Jones Indices does a well-known study of mutual-fund performance persistence, and generally finds that it is worse than chance: A fund that was above-average in the past has a higher-than-average chance of being below-average in the future. But Morningstar’s ratings have some modest predictive power. So at least for me, the take-away from “The Morningstar Mirage” is that Morningstar is better at picking mutual funds than I would have expected.

Matt Levine is a Bloomberg View columnist.