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Star Wars, the Sequel

Don Phillips: The Morningstar Rating for funds is a grade on past performance. Period.

Don Phillips, 08/12/2010

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The Morningstar Rating for funds is a grade on past performance. Period. No one at Morningstar ever claimed that the stars have predictive power or ever ran an ad telling investors to follow the stars to riches. Why, then, do they court such controversy when similar past-performance measures like alpha, the Sharpe ratio, and information ratios do not?

The principal argument against the stars is that investors use them as an easy answer instead of doing a deeper dive into fund research, but this is really a gripe with investor behavior, not the star ratings. People determined to take a short cut are going to find one. The question that should be asked is not whether the stars are preferable to full-scale research, but whether they are preferable to other shortcuts investors might take. As I pointed out in a recent column ("When You Wish Upon a Star," April/May 2010), the stars are infinitely better than the shortcut they've effectively replaced, short-term raw performance. Ironically, most criticism of the star ratings stems from the fact that they still include some past performance. What critics forget is that before the star ratings, investors looking for easy answers relied entirely on short-term performance.

By introducing cost and risk to the evaluation of past performance, the stars (following academia's lead) became a more complete grade on past performance. Moreover, they are truly objective, with a fully disclosed methodology and no subjective opinion. Like any historical grade, though, there are times when the past is not prologue to the future. Thus, the stars issued at the end of a bull-market run, say in 1999 or 2007, likely won't be a good predictor of performance in a subsequent bear market. Critics will always be able to find periods in which the stars don't correlate with subsequent returns. What they won't tell you is that there are as many, if not more, periods in which the stars do correlate with future performance. Neither set of data, however, proves that the ratings do or don't "work." They simply tell you that the past doesn't predict the future--something any reasonable person already knows. Investors using the stars, or any historical grade, must assess to what degree they believe the future will be like the past.

In that sense, the stars are much like the grades a student gets in school. We all know that not every A student goes on to successful employment. Similarly, some C students blossom later in life and have fine careers. No one (save a C or a D student, perhaps) would argue that employers shouldn't look at grades when hiring someone out of school. Good grades document past success and are likely to be correlated with virtues such as dedication, intelligence, and time-management skills, just as the star ratings correlate with low cost, low risk, and long manager tenure. To dismiss school grades for not being a perfect predictor of employment success risks missing valuable insights into an applicant's character.

Obviously, grades won't tell you everything about an applicant. Accordingly, a skilled recruiter evaluates further evidence in determining whom to hire. Indeed, this is where recruiters demonstrate their value over a simple ranking of candidates' GPAs. Advisors choosing funds are in the same position. Rather than griping about having to explain away a low rating for a fund they've selected for their clients, wise advisors will use such situations to showcase their ability to look beyond the numbers. By articulating how their knowledge of clients' goals and their forecasts of future trends make past performance an imperfect guide to the future, advisors prove their worth to clients. For 5-star funds, advisors should be able to explain why the past is prologue; for 2-star funds, why it isn't. In either case, the rating contributes to a valuable discussion.

I'm not arguing for the supremacy of the stars, simply that they have utility that their critics often overlook. The stars are a useful tool and, with more than 10,000 funds to choose from, a necessary screen. It clearly makes sense to search for future winners among those funds that have demonstrated past success, have low costs, and have taken prudent risks. Advisors still must ask whether the people, practices, and market environment that allowed the fund to succeed are still in place, in order to be able to project past successes forward. The absurd alternative would be to screen for funds with bad historical performance, much volatility, and high costs and purchase them on the hope that somehow they get their acts together.

Think of the stars as a test of achievement, rather than aptitude. To fault them for not being the latter risks losing the benefits of the former. Like school grades, their utility lies not in segregating different levels of performance, but in inspiring participants to strive for excellence. In that view, the stars do the fund community a great service. Who doesn't want their managers aspiring to better long-term, risk- and cost-adjusted performance?

Don Phillips is a managing director of Morningstar, Inc.
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