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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
The Wall Street Journal

Oct. 25, 2017

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.”

The firm sends conflicting signals about the star ratings’ predictiveness. A study published by Morningstar last month said the stars point investors to funds “likelier to outperform in the future.”

Morningstar founder Joe Mansueto said in an interview that the firm’s analysis of past ratings found “some modest predictive value.” Chief Executive Kunal Kapoor, in another interview, called the star system “a better predictor than it ever has been.”

In its written statement to the Journal, Morningstar said its analysis has found “the Star Rating is moderately predictive,” which “conforms to what we’d expect of a backward-looking, entirely quantitative measure.”

The Journal’s analysis found that most five-star funds perform somewhat better than lower-rated ones, yet on the average, five-star funds eventually turn into merely ordinary performers.

Inside Morningstar, some employees have expressed discomfort about how much investors rely on the ratings. Stephen Wendel, head of behavioral science at the Chicago-based firm, wrote in the June/July issue of Morningstar magazine that part of his job was “examining whether we are contributing to abuses in the industry,” and said: “Morningstar’s star ratings for funds are clearly used in the industry to imply that funds that performed well in the past will do so in the future.”

He added, “That needs to change.”

Morningstar’s Mr. Mansueto, 61 years old, said the star rating system “is a way to whittle down a big universe into something more manageable.” The firm said it has worked to make investors understand the star ratings should be just a starting point for their research.

Since 2011, Morningstar has had a second rating system, lesser known and of limited scope, that includes analysts’ opinions. Unlike the star ratings, it is designed to be forward-looking, Morningstar says. In this system, too, the Journal found the performance of funds rated high, low and in between tended to converge after several years. In addition, the Journal found Morningstar only rarely gave funds the lowest analyst rating, “negative.”

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