Morningstar Star Ratings Vs. Expense Ratios

August 12, 2010

Morningstar admitted recently that fund expense ratios were better at predicting future performance than its 'star' ratings. Things are worse than it says.

The new research piece, “How Expense Ratios and Star Ratings Predict Success,” was written by Morningstar Director of Research Russel Kinnel. It’s an important topic.

The Morningstar star ratings evaluate funds based on their risk-adjusted trailing performance, assigning ratings of one to five stars for every fund with a three-year track record. Funds that receive four or five stars regularly use that rating in advertising. Even though all mutual fund ads disclaim that “past performance is not indicative of future results,” that’s not how people see it. People associate good Morningstar ratings with good future performance, which is precisely why they are used so widely when marketing funds.

It’s also why I was so interested in this study. We’ve criticized the Morningstar ratings extensively in the past, precisely because they aren’t good predictors of future returns. I put myself in Vanguard founder Jack Bogle’s camp. He argues that, before costs, mutual funds will collectively deliver the market’s average return. Therefore, the best way to capture above-average returns is to buy funds with the lowest possible expense ratio. Anything else is essentially luck.

Kinnel’s latest study put that to the test. The findings were nuanced but boiled down to Kinnel writing this: “How often did it pay to heed expense ratios? Every time. How often did it pay to heed the star rating? Most of the time, with a few exceptions.”

The hedging is telling. Kinnel couldn’t have been more clear on the importance of expense ratios. “In every single time period and data point tested, low-cost funds beat high-cost funds.” But when it comes to star ratings, there were asterisks and qualifications and caveats.

I’ll add one more. Whatever success Morningstar’s ratings have is likely explained to a large degree by expenses, since star ratings are based on after-fee returns. Back out the impact of those fees and I’m guessing there’s not much left for the Morningstar ratings to stand on.

Individual analysts at Morningstar almost all demur on the value of the star ratings. As the comments on Kinnel’s piece indicate, some of them love Active Share and some of them love Manager Tenure and some of them (the smart ones) love managers who have “skin in the game,” i.e., managers who have their own money invested in the funds they run. But almost all of them I’ve met agree that the Morningstar ratings don’t do much.

And yet, the ratings persist. In fact, they are pervasive. Why? Because they’re easy to understand and make for good advertising. In other words, it’s style over substance, and it has cost investors a lot of money over the years.


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