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.