Money Managers Weigh In On Vexing Morningstar Ratings

A new study has some analysts questioning the effectiveness of Morningstar’s fund rating system.

Only 12 percent of Morningstar five-star funds maintained that pristine rating five years later, according to the Wall Street Journal report. Ten percent of five-star picks wound up being one-star picks over the same timeframe.

Those statistics prompted renewed criticism of Morningstar, with some investment industry observers questioning the ratings, while others are standing by the system.

“Morningstar is absolutely overrated,” said Alexander Lowry, a finance professor at Gordon College. “If a fund isn’t four-star or five-star rated then it might as well be dead in the water. Funds follow Morningstar ratings, for better for worse.”

Every fund financial disclosure emphasizes that past results are not indicative of future performance, yet all Morningstar measures is past results, Lowry noted.

“That’s what the mass audiences use to decide where to move their funds,” he explained. “Just because a fund has a strong past track record, that doesn’t mean it will necessarily be a good place to invest in the near-term.”

Morningstar disputed Lowry's comments, pointing to methodologies that are "forward-looking," including the Morningstar Analyst Rating and the Morningstar Quantitative Rating.

Morningstar Responds

Morningstar refuted the WSJ findings in a statement.

"Using The Journal's own findings, we find that highly rated funds were far more likely to outperform low-rated funds in the future," stated Jeffrey Ptak, Morningstar's head of global manager research.

Others agree that using Morningstar regularly leads investors to better mutual fund quality.

“Most novice investors are far better off using Morningstar than not,” said Jonathan Maula, investment manager at Castle Hill Capital in York, Pa. “Doing so will directly lead them to low-cost, better-performing funds more often than not.”

One conflict is Morningstar offering its own mutual funds, which it announced in March 2017, Maula said.

“Morningstar obviously knows what investors look for in funds the most but you begin to wonder if this will conflict their ratings of competing funds,” he said. “It would still be wise to use Morningstar’s ratings rather than not, but we'll have to see if that changes once they begin to push their own product.”

Manager research analysts do not currently provide qualitative, analyst-driven ratings or opinions for investable products where a Morningstar investment management subsidiary performs services or acts as a strategist for model portfolios, Morningstar said in a statement.

"Consistent with Morningstar’s policies, manager research analysts will not produce ratings qualitative ratings or opinions for the Morningstar multimanager funds," added Sarah Wirth, media relations specialist for the company.

Some money managers don’t agree that Morningstar is helpful to investors looking for the right mutual funds.

“Morningstar star ratings provide a report card on past performance, and can be helpful only if used to a limited degree,” said Daniel Kern, chief investment officer at TFC Financial in Boston. “Star ratings are great for advertising, but unfortunately are lousy at helping investors make smarter decisions.”

Differing Opinions on Star Ratings

Star ratings for equity funds often lead investors astray, as today’s four- and five-star funds typically fail to sustain their outperformance, Kern said.

“The star ratings reinforce the behavioral tendency of investors to focus excessively on recent performance,” he said. “Star ratings can be helpful in identifying funds to avoid, as persistence of performance of low-rated funds tends to be higher than persistence of performance among highly rated funds.”

Star ratings may also be helpful in certain categories, such as taxable bond funds and asset allocation funds where a higher proportion of “winners” tend to repeat as winners, he added.

Perhaps the most important Morningstar research is not their rankings, but the finding that low-cost funds tend to be better performers than higher-cost funds.

“Information about costs may be a superior starting point for investors than star ratings,” Kern said.

Others say that Morningstar might play favorites, based on who’s using their rating system or not.

“In my past life, I ran outreach and marketing for Rhode Island’s 529 college savings plan,” said Peter Kerwin, a communications specialist at the University of Wisconsin School of Business. “I was the chief of program development for the Rhode Island Higher Education Assistance Authority and I worked closely with the Rhode Island Treasurer’s office.”

In 2010, after having weathered the storm of the 2008 financial crisis, Kerwin said his group’s 529 plan suddenly went from being in the top third/middle range to being ranked as the worst plan in the country. Morningstar gave the fund a "bottom" rating, Wirth said, which was then its lowest rating tier.

“As it turned out, our program manager (AllianceBernstein) had brought on a new CEO and one of his first acts was to stop paying for licensing agreements,” Kerwin claimed.

Kerwin's account is incorrect, Wirth said, noting that "asset managers’ licensing agreements are kept confidential from Morningstar manager-research analysts to prevent potential conflicts of interest."

The Bottom rating was driven by the plan’s aggressive asset allocation (which led to poor performance in the financial crisis) and concerns about personnel turnover at the program manager, AllianceBernstein, the Morningstar spokeswoman explained.

'We Were Getting Whacked'

The agreements allowed AllianceBernstein to run Morningstar rating information in their marketing, Kerwin claimed.

“It seemed pretty clear to me we were getting whacked for that decision, so I started digging into their ratings methodology and I found it was pretty much a disaster,” Kerwin said. “It was an opaque set of standards that allowed them to put their finger on the scale and reward or punish plans at will.”

Morningstar had five general categories of measuring plans, but they could assign different weights to findings in those categories, and that was a problem, he claimed.

There was no impropriety in how Morningstar rated the Rhode Island plan, Wirth said, recounting the company's history with the plan.

Morningstar maintained Bottom, and later Negative ratings, on the plan until AllianceBernstein hired Morningstar’s Investment Management group in 2014 to help manage a portion of the 529 plan, she said.

"At that time, we discontinued our Analyst Rating on the Rhode Island 529 plans, per our coverage policies," she said. "We resumed coverage in 2016, after Rhode Island chose a new program manager, Ascensus."

Rhode Island’s plan for residents is currently rated Silver based on its sensible asset allocation, strong underlying investments from Vanguard and iShares, and low fees.

Brian O'Connell is a former Wall Street bond trader, and author of the best-selling books, The 401k Millionaire and CNBC's Guide to Creating Wealth. He's a regular contributor to major media business platforms. Brian may be contacted at [email protected].

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