The Wall Street Journal
is again attacking Morningstar's
ubiquitious star rating system for mutual funds. The expose-length feature offers lots of details, yet fundsters may still find themselves scratching their heads over some critical questions that the paper fails to dig into.
First, let's consider the WSJ's
case against the star ratings system, developed by founder and executive chairman Joe Mansueto
in 1985, as the less-ubiquitous analyst rating system launched back in 2011. The star rating system is a purely quantitative, backward-looking system evaluating risk-adjusted performance within categories (among funds with at least a three-year track record). The article, "The Morningstar Mirage"
(by Kirsten Grind, Sarah Krouse, and Tom McGinty) in this morning's paper but posted online yesterday, is well over 5,000 words long, full of quotes and no comments and anecdotes and statistics and charts and Morningstar history. It is well worth the read for any fundster who cares about the Chicago-based investment research titan ... i.e. for any fundster who cares about the business. Juicy tidbits include a mention of who designed the M* logo and an aside about what M* might have used instead of stars to denote its ratings.
Here are the main concerns the article raises: 1) many five-star funds, especially five-star domestic equity funds, fall in performance in the years after being rated five stars; 2) M*'s newer, forward-looking, part-qualitative analyst ratings suffer the same problem when it comes to top-rated funds' subsequent performance; 3) investors and advisors and broker-dealers and others turn to ratings when choosing which funds to buy or recommend and which to drop or avoid altogether, and fund firms advertise funds' high ratings, which leads to; 4) highly rated funds dominate net inflows. Other side issues mentioned include: 5) fund firms pay M* for the right to advertise their funds' ratings, and 6) M* does not give analyst ratings to most funds, and most that do get such a rating get a positive one. Some of the concerns raised echo previous discussions from the likes of P&I
, Advisor Perspectives
, and even the WSJ itself
, at least twice
Given the power that M* ratings (especially star ratings) seem to have over fund flows, many fundsters may find the WSJ's
logic compelling and may even share some of the frustration or concern expressed by those quoted in the article. Yet there are counter-arguments, or at least counter-questions, to consider.
First, how do M* star ratings and analyst ratings compare to raw performance data, unadjusted for risk and perhaps only looked at on an absolute (and not a relative, within-category) basis? M* would probably argue, and may have the data to back up their argument, that in the absence of a star rating system that divides funds into categories and tempers raw performance with risk, investors might be even more prone to chasing hot dots and getting burned for it.
Second, how do the M* ratings compare to other systems that investors might use? Five years ago the New York Times compared
M* star ratings to M* analyst ratings, Lipper ratings, and S&P ratings.
Third, even if the M* ratings don't consistently predict future winners, do they give investors a meaningful edge in avoiding future losers? Many five-star funds today may revert to the mean or underperform in the coming years, but perhaps one-star or even three-star funds will do even worse on average. Indeed, M*'s own John Rekenthaler raised
this point three years ago, shortly after another (admittedly shorter) WSJ article
questioning the value of M*'s star ratings. A year earlier M*'s Annette Larson highlighted
the lower death rates of highly rated funds.
own data in the new article yesterday even lends credence to this counterpoint. One of the main charts shows how five-star funds perform over the next three, five, and ten years after the rating. Yet a quick visual comparison of that chart to the charts for funds with four, three, two, or one stars shows that the five-star funds do on average fare better performance-wise over the coming years and have substantially lower likelihoods of being liquidated. Yet despite the charts, the article does not really address this point at all, that ratings may be more useful for avoiding losers than for picking winners. And given what behavioral economics teaches us about humanity's propensity for loss-aversion, avoiding losers is an important thing in investing.
Fourth, M* knows the star ratings have limitations, has long warned
the industry and investors of those limitations, and even created
the analyst ratings to offer an alternative measuring stick
that better reveals aptitude
, not achievement. What's an investment research shop to do, given that investing is inherently quantitative and thus prone to simplification via basic, backward-looking, numerical comparisons.
M*'s own counterarguments, as of a month ago
, were three-fold: better-rated funds tend to be cheaper, easier to own, and more likely to outperform in the future. And this morning M* posted
a direct response to yesterday's WSJ
Yet perhaps this time the star ratings debate struck a chord with Mister Market, as pointed out by Seeking Alpha
. Yesterday M*'s stock (MORN on the NASDAQ) fell 4.65 percent (while the overall Nasdaq slipped only 0.52 percent and financials fell only 0.37 percent); that drop happened despite M* issuing Q3 2017 earnings
that showed double digit rises year-over-year in revenue and operating income along with a slight bump up in operating margin.
M* spokespeople, Mansueto himself, global director of research Jeffrey Ptak
, and CEO Kunal Kapoor
all chimed in for the WSJ's
latest piece. Some firms, including Morgan Stanley
and Kornizter Capital Management's Buffalo Funds
and a host of other asset managers "large and small", declined to comment. Those who did comment included: Michael Cuggino
, president of Pacific Heights Asset Management
, advisor to the Permanent Portfolio
family of funds; Donald DeMuth
, an FA in Mechanicsburg, Pennsylvania, and David Peterseim
, a client of DeMuth; John Gomez
, president of Nuveen's Santa Barbara Asset Management
; Craig Hodges
, co-founder of Hodges Capital Management
; Scott Jennings
, a former Morgan Stanley FA; Samuel Lee
, a former M* strategist; Mary McDonald
, board secretary of the Hickory Hills, Illinois police pension fund, and David Wetherald
, president of that pension board; Michael Rawson
, a former M* fund analyst; former Mansueto colleague Ralph Wanger
; and spokespeople for AB
Neil Anderson, Managing Editor
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