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Is the Morningstar Rating System All It’s Cracked Up to Be?

By: Investor Solutions

By: Investor Solutions, Inc.

The Morningstar rating system has gained a great deal of popularity since it was first established in 1985 by the Chicago-based company Morningstar. The reason for its fame is quite simple: most investors simply do not have the time or the know-how to properly sort through the immense universe of mutual fund data. The star ratings provide a simple and quick way to find the best mutual funds available.

But how reliable are the star ratings?

Simply put, the Morningstar rating system is designed to help investors find the best mutual fund for a particular asset category or sector (i.e. large cap, mid cap, technology…). It assigns one to five stars. Five stars are granted to the top performers and one and two are given to the funds that have lagged behind. Performance is not the only measure of success. Morningstar evaluators also look at the level of risk of the fund (fund managers are penalized for taking too much risk) and the costs associated with investing in the fund (lower ratings are assigned to expensive funds).

Most people using the rating system fail to realize the limitations. Let me enlighten you on some of its shortfalls:

  • The ratings are based on historical performance data. A score is computed for each of the following historical periods: three year, five year and ten year. While an evaluation of past performance may be interesting, it should not be the sole reason for an investor to buy a particular fund. As we all know, past performance does not guarantee future performance.
  • The star rating is essentially designed to measure mutual fund manager’s skill. When a person achieves above average result in a particular activity (an athletic activity or managing a fund), we automatically assume that it was a result of luck. The performance will only be attributed to skill when that person is able to continuously repeat its feat. Research has shown that above average performance in the world of active management is a matter of luck not skill. Studies by Davis (2001), Ibbotson & Groetzman (1994) have confirmed that there is no significant persistence in mutual fund performance. If there is no skill to measure, what is Morningstar evaluating?
  • Let’s assume for a minute that managers are skilled professionals. Unfortunately, the data periods used to measure their competence is just too short. A fund’s star rating is based on its three-year, five-year and ten-year weighted average return. According to Richard A. Brealey, a respected pioneer of capital market theory, “… you probably need at least 25 years of fund performance to distinguish at the 95% significance level whether a manager has above-average competence.” Unless Morningstar revamps their system to only grade funds twenty-five years or older, I suggest investors to stop gazing at the stars.
  • And finally, the star rating is a peer evaluation. It determines how well a mutual fund has performed in comparison to all the other funds in that same asset category. A five star rated fund is at the top of its class. The question is, how well has it done against the sector of the market it is trying to mimic?

In closing, the Morningstar database is certainly a wonderful tool for both advisors and investors to research fund information and classifications. But, investors that rely solely on the Morningstar “star rating” system to develop their investment strategy fail to acknowledge the tremendous impact that asset allocation and diversification will have on their results. Ninety-four percent of their successes are attributable to how the assets are divided between equity asset classes and bonds. Finding the best mutual fund determines a measly five percent of the final results. Therefore, the driving factor in your decision making should be asset allocation and diversification and not stock or mutual fund picking.