What does Morningstar Inc say its mutual fund stars cannot do?

Morningstar has stated that its stars cannot provide a single fund screening and selection measurement nor predict future mutual fund performance. Morningstar’s position on performance prediction contrasts with the actions of many mutual fund investors who apparently believe that the star rating system has predictive powers.

This article utilizes materials from Morningstar’s website and a published interview to summarize what representatives of Morningstar, Inc. say the Morningstar Ratings* cannot do.¹ The Skilled Investor makes no claim that this article exhaustively summarizes all of Morningstar’s commentary on what its star ratings cannot do, nor does it necessarily represent Morningstar’s best thinking on these topics. Only Morningstar could provide such information. For more information on this subject, please refer to www.morningstar.com. (See this related article, What does Morningstar, Inc. say its mutual fund stars can do?)

Morningstar, Inc. has offered the following cautions about what its stars cannot do:

• Provide a single fund screening and selection measure²

• “The Morningstar Rating is intended for use as a first step in evaluating an investment. A high rating alone is not sufficient reason for investing in a particular mutual fund.”³ 

• “The star rating will continue to work best as a screen that will help you narrow a crowded mutual fund field down to a more manageable size. In addition, you can use it as a quick check on funds already in your portfolio. Thus, we believe they will prove to be valuable time savers that will help you navigate your way through an enormous universe of choices. In both cases, though, it can’t make the final decision for you. You’ll still need to do fundamental analysis of the strategy and management in order to figure out if the star rating is a true reflection of a fund’s prospects. Our Analyst Reports will help with that.”⁴

• Predict future mutual fund performance

• Historically, Morningstar, Inc. has avoided making any claims about the ability of its star rating system to forecast mutual fund returns.

• For example, during an interview with Kiplinger’s, Morningstar managing director Don Phillips made the following comments:

• Kiplinger’s Question: “So how should the star system be used by investors?”

• Phillips: “As a way of identifying funds that have had success in the past.”

• Kiplinger’s Question: “That’s a pretty modest role. Can’t you claim predictive values? Don’t funds with the most stars tend to be the best funds subsequently?”

• Phillips: “The stars take into consideration performance, all costs and risk. And performance is probably the weakest of these factors in terms of projecting from the past into the future. Think of this as a poker game. When you’re trying to figure out who to place your bets with, to some extent you want to go with those who have had the most success. But knowing who won the most in the past won’t tell you who will win the most next week or next month.”⁵

• However, recently Morningstar published an article in late 2004 suggesting that preliminary data on the new Morningstar Ratings could have some predictive value regarding performance. (See: Do the "new" Morningstar star Ratings predict superior fund performance?)

Sometimes Morningstar’s commentary on the star rating system gives rise to ambiguities. For example, Morningstar’s 2002 Fact Sheet on the revised star rating system said: “Because the funds in a given category are similar in their risk factor exposures, the observed return differences among them relate primarily to security selection (“stock picking”) or to variation in the timing and amount of exposure to the risk factors that collectively define the category (“asset weighting”). Each of these, over time, may be presumed to have been a skill-related effect.”⁶

Because this Morningstar statement argues that past performance is presumably due to fund management prowess in stock picking and/or market timing, one then needs to believe that such measured skill actually exists and that it explains past differences in management performance. However, Morningstar’s lack of confidence in the predictive abilities of its stars regarding performance would seem to imply that some other unspecified factor must causes an interruption in the continuity of this skilled performance record of accomplishment. This unspecified factor must be operating quite frequently, because Morningstar Ratings have been highly unstable over time (See: How stable have Morningstar Ratings for mutual funds been over time? and What the instability of mutual fund Morningstar Ratings means for long-term investors – Commentary)

We are left with the classic quandary about active investment management. How much is skill and how much is luck? The scientific finance literature on this topic indicates very little evidence of superior, skill-based performance persistence for active management. Moreover, if it exists, its value to investors tends to be greatly outstripped by the high fees charged by active managers.

The only compelling evidence about mutual fund return or performance persistence is that very poor performance in the past is more likely to continue into the future. (See: Do Morningstar Ratings predict risk-adjusted equity mutual fund performance?)

Finally, note that Morningstar’s position on the efficacy of its star ratings from a performance prediction standpoint contrasts with the actions of many mutual fund investors who apparently believe that the star rating system has predictive powers concerning risk-adjusted returns. (See: Does it pay to trade when the Morningstar Rating of a mutual fund changes?)

Also, see these related rating service articles about Morningstar:

• Morningstar Ratings should be used with caution
• The quality of the old Morningstar Ratings prior to mid-2002
• What does Morningstar, Inc. say its mutual fund stars can do?
• What does Morningstar, Inc. say its mutual fund stars cannot do?
• Simplifying investment decision making can be taken too far
• High Morningstar Ratings can lure you into funds with costly sales loads
• How stable have Morningstar Ratings for mutual funds been over time?
• What the instability of mutual fund Morningstar Ratings means for long-term investors – Commentary
• Does it pay to trade when the Morningstar Rating of a mutual fund changes?
• What might be wrong with buying a mutual fund with a 4 or 5 star Morningstar Rating?
• Do Morningstar Ratings predict risk-adjusted equity mutual fund performance?
• Do mutual fund Morningstar Ratings changes influence individual investors?
• Investment astrology – should you pick investments according to the Morningstars?
• How the new Morningstar Ratings for mutual funds have been determined since mid-2002
• How Morningstar Ratings for mutual funds are used as a marketing tool

* The Morningstar Rating is a trademark of Morningstar, Inc. The Morningstar Rating has also been referred to in the media as the Morningstar stars, the star rating, the star rating system, etc.

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1) http://www.morningstar.com (Note that morningstar.com is a website for individual investors, and datalab.morningstar.com is a website for institutional and advisor clients.)
2) Morningstar, Inc. “Fact Sheet: The New Morningstar Rating(tm) for Funds.” 2002  http://corporate.morningstar.com/US/documents/MethodologyDocuments/FactSheets/MorningstarRatingForFunds_FactSheet.pdf
3) Morningstar Press Release: “Morningstar, Inc. to Change “Star Rating” for Funds – Moving to Category-Based Rating, Enhancing Risk-Adjusted Return Measure.” April 22, 2002. http://www.morningstar.com/press/release/item/0,1045,648,00.html
4) Benz, Christine. “Special Report: Introducing Morningstar’s New Star Rating.” July 03, 2002.   http://news.morningstar.com/article/article.asp?id=77455&_QSBPA=Y
http://news.morningstar.com/doc/article/0,1,77455,00.html (Note that Morningstar Analyst Reports are another Morningstar proprietary service available to subscribers as part of its Premium Membership.)
5) Schiffres, Manuel and Steven T. Goldberg. “The World According to Morningstar.” Kiplinger’s Personal Finance Magazine. February 1997, Volume 51, Issue 2
6) “The New Morningstar Rating Methodology” Morningstar Research Report, 22 April 2002. page 7 http://datalab.morningstar.com/Midas/PDFs/Research_StarRating.pdf