More and more, we seem to be living in a world of ratings and “likes.” They may be easy ways to track the collective opinion of friends or customers, but they’re not always accurate or appropriate for making many types of important decisions.
Take investments—this is one area where people should be particularly on guard against emotional appeals and impulses to follow the crowd. Yet, this is often what happens when investors see Morningstar ratings, one of the most popular rating systems for mutual fund investments.
Investors gravitate toward top-performing funds—those that receive 5-star rankings from Morningstar tend to attract new investors and fresh inflows of money. But star ratings can only tell investors about past performance—they’re not reliable predictors of what future performance will be.
All or Nothing
These days, it seems as if every business either has a five-star or a one-star rating. For example, a Cornell University analysis of more than 1 million hotel reviews on travel site TripAdvisor found that 70% of reviews were positive (either 4- or 5-star reviews,) while only 15% ranked in the bottom two categories (1- and 2-star reviews.)
From looking at ratings alone, it may appear that most hotels are above average. Any frequent traveler knows this is not the case.
But this phenomenon also appears among UBER drivers—the vast majority have ratings of 4.6 or higher on a 5-point scale. In fact, the company says only 3% of drivers have ratings less than 4.6, which is the red line at which bad drivers risk being kicked off of UBER’s platform.
Investors tend to be fond of ratings, too. Morningstar’s rating system has been around since the firm introduced it in 2003. Their star ratings can be a helpful tool for quickly evaluating and comparing fund returns and risks. Where TripAdvisor and UBER ratings are based on subjective measures of customer opinion, Morningstar ratings are more helpful in that they are calculated using empirical data—specifically, a Morningstar risk-adjusted return that is computed using the company’s proprietary algorithm.
When ranked by this risk-adjusted return figure within their Morningstar-assigned category, the top 10% of funds receive a 5-star rating for the time period surveyed, and the next 22.5% of funds receive a 4-star rating. On the other end of the scale, the bottom 10% of funds receive a 1-star rating. A fund’s overall star-rating is a blend of its 3-, 5- and 10-year ratings if available, with the 10-year rating receiving the heaviest weighting in the overall score.
Limited Reach
Morningstar ratings make it easy to compare fund performance within a specific asset class or category. As mentioned, there are limitations to their effectiveness because the ratings are based on past performance.
A recent analysis by the Wall Street Journal underscores just how limited Morningstar ratings can be. Funds that had received 4- or 5-star ratings ten years ago tended to revert to the mean—a decade after receiving the highest Morningstar ratings, these once top-rated funds are now squarely in the middle of the pack with an average 3-star rating.
It doesn’t take long for 5-star funds to fall from grace—only 14% of funds receiving a 5-star rating maintained that ranking three years later. And more than a quarter had fallen to the lower rungs of 1- and 2-star funds.
Morningstar ratings can be one of many steps used for fund analysis, but they can also seem more useful as marketing tools by fund companies looking to attract investors to their strategies. Fund firms tout their 5-star ratings in advertisements and brochures because inflows are sure to follow. The WSJ analysis bore this trend out—top-rated funds saw healthy net inflows into their strategies, even after the performance began to decline. On the flip side, cellar-dwelling funds with low Morningstar ratings saw net outflows of investor money, which continued even after performance improved.
Catch a Falling Star?
Given these figures, investors might assume it would be better to follow a contrarian strategy, shunning the popular 4- and 5-star rated funds in favor of unloved low-ranking funds. Unfortunately, the Journal’s research shows that ugly-duckling funds aren’t likely to turn into swans. Only 5% of 1-star funds achieved 4- or 5-star status ten years later. The majority of 1-star rated funds were either liquidated or merged into other funds in the convening years, victims not only of poor performance but also a loss of investor confidence and withdrawals of assets.
Can star ratings indicate future success? Not entirely, because performance for most highly-rated funds tends to decline over time. But a few shining stars do emerge—while just 14% of 5-star funds 10 years ago remained in the top tier, funds with lower ratings were even less likely to move up to the highest level, according to the Journal’s analysis.
Does this mean Morningstar’s rating system is spurious? No, but investors should view these ratings for what they are—a measure of past performance and a helpful tool for comparing different funds and managers within a particular asset class or fund category. Morningstar ratings are one resource of many available to investors, plan sponsors and advisors to help them make prudent decisions about investing for the future.
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