The Wall Street Journal says that funds given a top “star” rating by Morningstar won’t be top performers. But the Journal’s findings are neither new nor as conclusive as its article states.

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Morningstar
By Kopiersperre [Public domain], via Wikimedia Commons
The Wall Street Journal published its findings in a long investigative article, “The Morningstar Mirage,” which appeared on October 25, 2017. Morningstar responded with articles by three of its executives – Don Phillips, Kunal Kapoor and Jeffrey Ptak.

The Journal’s central claims were that a high percentage of top-rated (five-star) funds don’t maintain their top ratings over time, but that achieving that five-star rating attracts significant flows from investors. As a result, it claims, investors have suffered by choosing top-rated funds.

Morningstar’s response centered on the fact that, as the Journal’s findings demonstrated, five-star funds maintained higher ratings than four-star funds over the time period studied. Similarly, four-star funds maintained higher ratings than three-star funds, and so on. Thus, choosing a higher rated fund gave investors an advantage.

The performance deterioration of top-rated funds has been known as far back as 1999, in a study by Matthew Morey and Christopher Blake in Morningstar Ratings and Mutual Fund Performance and by Morey in 2003 in “Kiss of Death: A 5-Star Morningstar Mutual Fund Rating?” The fact that asset flows follow top-rated funds was documented in 2001 by Diane Del Guercio and Paula Tkac in “Star Power: The Effect of Morningstar Ratings on Mutual Fund Flow.” Several studies have been published since these papers confirming, updating and expanding their findings.

The Wall Street Journal failed by not acknowledging this prior research. It led its readers to believe that it had discovered previously undocumented relationships.

But the core issue is whether Morningstar’s “star” ratings are a reliable guide for investors and advisors. On this point, Morningstar has consistently maintained that its ratings are “moderately predictive” of future performance and are a “starting point” for future research. (It makes stronger claims with regard to its analyst ratings, which I will come back to later.)

The Wall Street Journal acknowledged that it was aware of the extent to which Morningstar claimed its star ratings had predictive power.

Given the modest claims Morningstar makes and has made with regard to its star ratings, its response to The Wall Street Journal’s claims is a sound defense. If it is a battle words over the semantic issue of the meaning of “moderately predictive” power, Morningstar is the victor.

By Robert Huebscher of (on behalf of) IMCA, read the full article here.