What Really Shines Through in the Morningstar Rating for Funds

In a bit of logical inconsistency, the critics who fault the Morningstar Rating for funds generally praise the investment attributes that the stars promote. After all, if you ask commentators who are chastising the ratings for a list of funds they think their clients or readers should buy, the list typically consists of a group of funds that inevitably carry strong star ratings. Or they will suggest a list of attributes--such as low costs, lower volatility, or longer manager tenure--that are highly correlated with the very ratings they dismiss. If you're intellectually honest, you can't claim that the stars mislead when they lead to the characteristics you embrace.

Nevertheless, picking on the stars is, quite simply, an easy way to garner headlines. 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 offer a quick summation of favorable attributes, and, as such, 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 promoting 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, as top performers tend to cool and weaker 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 to keep investors on board to actually realize the benefits of fund ownership. Higher-rated funds not only have better historical returns, but they have better investor returns than low-rated funds, meaning that they identify funds that investors are apt to deploy more successfully.

Less well appreciated, but of even greater value, is how the star ratings systematically point investors toward lower-cost funds--a virtue that even their sternest critics should concede. They also showcase funds with more seasoned managers who trade less (especially on the equity side) and who are more willing to invest their own capital alongside shareholders'--virtues that have gone largely unrecognized, but ones that clearly have merit.

Let's look at costs first. As seen in the chart below, 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, which the star ratings effectively replaced, do not.

Moreover, because stars are associated with lower turnover, there is less frictional trading cost in higher-rated funds than in low-rated ones, further adding to the cost advantages of higher�rated funds. (This trend is somewhat obscured when you look at all funds together, as 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 extremely 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.

Next, consider manager tenure and manager investment in their own funds and how these attributes correlate with the stars. As fund companies tend to retain managers with better ratings and dismiss those with weaker ones, investing in a higher-rated fund means you're likely to get a more seasoned manager. Prioritizing better-rated funds also means you're apt to get a fund where the manager has more skin in the game. The numbers below are derived from the recently required disclosure of manager stakes in their funds. There's a strong linear 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 complex investment decisions, investors are always going to seek an easier path--the only question is which one. Few short cuts are more defensible or lead investors to a more attractive set of attributes than the Morningstar star rating. Imagine if fast food outlets offered up fare that was systematically 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.

High Star Ratings Point to Impressive Attributes
--------------  3 Year ---------------                     ------ Load ------
Star Rating	Total Ret	Inv Ret	Stnd Dev	Exp %	Front	Back	Turnover	Tenure	Mgr Invt
5	1.02	1.32	16.57	1.14	0.29	0.22	112	6.2	$300,061
4	-1.36	-1.84	17.52	1.21	0.51	0.39	90	6.3	$250,890
3	-3.10	-5.62	18.26	1.27	0.73	0.54	123	5.4	$161,602
2	-4.62	-5.86	18.71	1.43	1.08	0.86	123	4.6	$124,810
1	-7.65	-8.69	21.31	1.55	1.12	1.01	146	3.8	$110,991
Data as of 1/31/10