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Tuesday, June 01, 2010

Revisting the Star Debate

News summary by MFWire's editors

The WSJ's Sam Mamudi wades into the two decade old debate over the utility of Morningstar's star ratings in Tuesday's Fund Track. Do they have value? Are they too backward looking? Are they predictive of performance? Those are questions, that even if answered, may not alter behavior. More importantly, are they still predictive of fund flows?

Mamudi takes definitive stands on all of the questions: "The trouble is that investors seem to forget that star ratings are backward-looking, based on a fund's past performance, and studies have shown the ratings have no predictive value," he writes.

When it comes to flows, Mamudi cites Morningstar research through the end of last year that shows that of $2 trillion of net inflows four-star- and five-star-rated funds took nearly three quarters (72 percent) of the roughly $2 trillion of net inflows into all star-rated funds. Quick math suggests those top two tiers grabbed $1.5 trillion in net flows.

Most of the rest went (30 percent) into three star funds with just 1 percent hitting two star funds (one star funds saw net outflows.

The trouble with those flow numbers is that they cover a ten year period and that period saw significant change in how funds are distributed. A decade ago, for example, Merrill Lynch still promoted its funds solely through its own platform (and yes, it still had its own funds). On the direct-sold side investors still wanted high tech stock funds and not bond funds.

More recent numbers suggest that five-star funds shine even more brightly now. In 2008 five-star funds were the only ones with net inflows ($67.5 billion), while four-star funds saw outflows of $14 billion and all non-five-star rated funds saw $111 billion flow out the door. 

Edited by: Sean Hanna, Editor in Chief

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