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When You Wish Upon a Star

Don Phillips: The Morningstar Rating for Mutual Funds isn't perfect, but it's directionally right.

Don Phillips, 04/29/2010

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Critics like to demonize the Morningstar star ratings, yet in a bit of logical inconsistency, they generally praise the exact investment attributes that the stars promote. It's common to see someone chastise the ratings, but when pressed for the funds they think investors should buy, they name funds that carry strong star ratings or list attributes--such as low costs, low volatility, and long manager tenure--that are highly correlated with the very ratings they dismiss. You can't claim that the stars mislead if they lead to the funds or the characteristics you embrace.

Nevertheless, it remains fashionable to disdain the stars. Some critics sniff that they won't use them. Others regale in tales of their occasional underperformance (while ignoring positive studies). All of which is fine. We never made any claims that the ratings were predictive of short-term performance or that they can take the place of a skilled advisor. We merely say that the ratings form a better starting point for fund research than the short-term raw performance numbers that investors formerly used as their primary research tool.

Perhaps if the true intent of these critics was to promote sound investment counsel, they'd take a more generous stance toward the stars. After all, one would be hard pressed to find a system that pointed investors toward a more impressive set of attributes than do the stars. Obviously, the stars highlight funds with better historical performance--that's in the methodology--but that is most likely the stars' weakest virtue. Top performers tend to cool and weak performers often make changes that improve performance. Of more enduring value is how the ratings favor lower-risk funds. As our work with dollar-weighted returns has shown, lower-volatility funds are much more likely than higher-volatility funds to keep investors on board to realize the benefits of ownership. Funds with high ratings not only have better historical returns, but they have lower risk and better investor returns than low-rated funds, meaning that the stars identify funds that investors are apt to deploy more successfully.

(View the related graphic here.)

Less appreciated, but of even greater value, is how the stars point investors toward lower- cost funds. As seen in the chart, expense ratios line up inversely with star ratings, as do front-end loads and deferred loads. The stars clearly point investors toward lower-cost options, something that short-term performance rankings do not. Moreover, because stars are associated with lower turnover, there is less frictional trading cost in higher-rated funds than in lower-rated ones, further adding to the cost advantages of high-rated funds. (This trend is somewhat obscured when we look at all funds, because the relationship between ratings and turnover is weaker on bond funds--many 5-star bond funds like PIMCO's have high turnover--but it is strong on stock funds, with an average turnover rate of 87% for 5-star funds and 153% for 1-star funds.) Few tools have done more to encourage investor thrift than have the stars.

The stars also showcase seasoned managers who are more willing to invest their own capital alongside shareholders'. Fund companies tend to retain managers with better ratings and dismiss those with weaker ones, meaning that you're likely to get a more seasoned manager if you buy a top-rated fund. Prioritizing better-rated funds also means you're apt to get a fund where the manager has more skin in the game. The numbers above, which are derived from the recently required disclosure of manager stakes in their funds, show a stunning relationship between star ratings and a manager's willingness to put his or her own money on the line. Clearly, the stars identify characteristics that fund companies and fund managers themselves value.

Given the difficulty of making investment decisions, investors are always going to seek an easier path--the only question is which one. Few short cuts lead investors to a more attractive set of attributes than the stars. Imagine if fast-food outlets offered up fare that was lower in fat and calories and higher in vitamins and fiber than what diners would otherwise choose. That's essentially what the stars offer. They're not perfect, but they're directionally right. So the next time you hear someone bashing the stars, you might want to ask if they are doing this for self promotion or if they genuinely are opposed to better investor returns, lower risk, lower cost, lower turnover, longer manager tenure, and greater manager investment.

Don Phillips is a managing director of Morningstar, Inc.

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