Morningstar Mirage

It's Black Friday – a day of deals, but also impulse buys that only look like good deals. On this occasion, I want to warn of a hidden game within the mutual fund arena – yet another “auto-pilot” part of the multi-trillion-dollar investment business, where investment Advisors / RIA’s allocate money to mutual funds that are rated 5 stars by Morningstar, yet by and large, massively underperform. It would boggle your mind to know how little investment analysis / “kicking the tires” is going on behind the scenes. We can do better. –Glenn

MORNINGSTAR MIRAGE

Investors everywhere think a 5-star rating from Morningstar means a mutual fund will be a top performer—it doesn’t

By Kirsten Grind, Tom McGinty and Sarah Krouse

Millions of people trust Morningstar Inc. to help them decide where to put their money.

From pension funds to endowments to financial advisers to individuals, investors rely on Morningstar’s star ratings to help divide $16 trillion among America’s mutual funds, in much the way shoppers use Amazon’s ratings to pick products. A lot of these investors, and the people paid to guide them, take for granted that the number of stars awarded to a mutual fund is a good guide to its future performance.

By and large, it isn’t.

The Wall Street Journal tested Morningstar’s ratings by examining the performance of thousands of funds dating back to 2003, shortly after the company began its current system. Funds that earned high star ratings attracted the vast majority of investor dollars. Most of them failed to perform.

Of funds awarded a coveted five-star overall rating, only 12% did well enough over the next five years to earn a top rating for that period; 10% performed so poorly they were branded with a rock-bottom one-star rating.

The falloff in performance was even more dramatic for domestic stock funds, the largest category of U.S. funds by assets.

Billions of investor dollars hang in the balance. Nearly every asset manager in the world pays Morningstar for data services. Some 250,000 financial advisers rely on Morningstar’s data, services or ratings, according to the firm. That means Morningstar’s analysis and ratings influence investment decisions for a vast landscape of retirement plans and brokerage accounts.

Morningstar’s reach is so pervasive that the ecosystem for buying and selling mutual funds revolves around it. Fund companies heavily advertise their star ratings. Money typically pours into funds after they receive a five-star rating from Morningstar, the Journal found. It flows out if they lose stars.

There is no question that Morningstar has greatly improved the transparency and rigor of data on mutual funds’ holdings and performance, making it easier for individual investors to compare funds.

Morningstar says it has never claimed its star ratings suggest how funds will perform in the future. The star system is strictly backward-looking, assessing past performance, the firm says.

“We have always been very clear that it’s not intended to predict future performance,” the company said in a written statement.

“The star rating works well when it’s used as intended: as a first-stage screen that helps identify lower-cost, lower-risk funds with good long-term performance,” Morningstar said. “It is not meant to be used in isolation or as a predictive measure. Reversion to the mean is a powerful force that can affect any investment vehicle.”

Read the full piece: https://www.wsj.com/articles/the-morningstar-mirage-1508946687