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Advisor Insights

The Utility of Grades

The star rating creates the incentives we all want fund managers to have.

In the mid-1980s, as the number of U.S. mutual funds swelled past 1,000, it became clear that an individual investor or financial advisor could no longer perform due diligence on all the available choices. Some sort of screen or means of grading the prospects had become essential. Joe Mansueto, publisher of the newly launched Mutual Fund Sourcebook, responded to this challenge by introducing the Morningstar fund ratings ranging from 1 to 5 stars to help investors more quickly identify funds with better records.

Joe borrowed from the academic thinking of the time, which argued that funds should not be evaluated over quarters or calendar years, as was then the fashion, but instead should be assessed based on longer periods. Joe set three years as the minimum evaluation period and gave greater weight to the five- and 10-year records when available. Academics also urged investors to consider the risk that funds took to achieve their gains and the costs that they imposed on investors. Costs were a significant and challenging thing for investors to grasp, as front-end sales charges were then frequently as high as 8.5% and fees had recently been complicated by the introduction of deferred loads and 12b-1 fees. In addition, some funds charged loads for the reinvestment of income distributions, while others did not. At the time, many performance evaluations simply ignored most costs and did nothing to address the risks a fund took.

The star rating thus represented a considerable leap forward. Adding cost and risk to the notoriously fickle element of performance was a major improvement, as costs and risk could be better taken from the past and projected into the future. High-cost funds don’t suddenly become cheap. Managers who are naturally risk-averse don’t randomly start buying dicier companies or taking big sector bets or stretching for yield. Risk, unlike performance, is somewhat a matter of choice. While the star ratings didn’t speak to the people behind the performance or their process (Morningstar would address those concerns later as it fought for the disclosure of manager names and incentives), the stars did present a more intelligent starting point than the system of short-term, raw performance screens they replaced.

From their introduction, Morningstar displayed the star ratings in context with scores of other data points. They were a reasonable place to begin a search, as it obviously makes more sense to focus on funds that have demonstrated success— and then to dig deeper to see if there is reason to expect the success to continue—than it does to concentrate on funds with poor performance, high costs, and high volatility on the hope that they may correct those flaws. Moreover, Morningstar consistently spoke of the stars in sober terms, trying candidly to describe both their advantages and their limitations. The stars are a starting point, not a conclusion— a grade, not a prediction.

Nevertheless, some observers insist on evaluating the stars as predictions. Multiple popular and academic studies explore the predictive power of the stars. Most find the stars to be precisely what Morningstar itself has long said—the stars are mildly predictive. In 2016, we removed the load adjustment from the calculation, as empirical data suggested that few investors were paying these loads anymore. But because long-term returns and ongoing expenses have a negative correlation, the stars still effectively tilt investors away from high-expense funds, and they modestly up the odds of good investor outcomes. Not bad for a first-stage screen. Still, it’s fashionable for advisors to disparage the stars, often offering their preferred alternatives as a better path. “Just buy low-cost index funds” and “just buy funds from a favored provider like DFA or American Funds” are popular advisor refrains. Invariably, however, these alternative approaches correlate strongly with what the stars already tell investors. Low-cost, broad-market index funds have consistently held above-average star ratings, as have the DFA and American Funds groups. The stars can hardly be misleading investors if they suggest the same conclusions their critics urge. I’ve met many advisors who deride the stars, but I’ve yet to meet one whose own recommendations don’t skew toward higher star ratings. Few if any people build consistently winning portfolios out of 1- and 2-star funds.

Moreover, these critics overlook perhaps the stars’ greatest benefit. The stars, by rewarding better long-term, risk-adjusted performance, encourage more prudent behavior among managers. They create precisely the incentives that a rational investor would desire their manager to have— a focus on the long term, pressure to lower costs, and disincentives to take wild risks.

Schools don’t assign grades to help future employers identify the best hires; schools assign grades to motivate better student behavior. So, too, do the stars discipline managers to behave in a more shareholder-friendly manner. In effect, the stars shift performance evaluation from something fund managers crave—a tool to promote short-term sales while camouflaging costs and risks—into something that investors and their advisors want— incentives for greater prudence and predictability in the management of their assets. That’s a 5-star outcome.

This article originally appeared in the April/May 2018 issue of Morningstar magazine. To learn more about Morningstar magazine, please visit our corporate website.