Morningstar, the mutual funds research service famous for its star ratings of funds, apparently issued a press release over the weekend that details a study of its star ratings vs. other fund selection criteria. I say “apparently” because both the Wall Street Journal and the Associated Press carried the story, but I’ve been unable to locate either the press release or the research document on the Morningstar website.
Two aspects of the WSJ account of the study struck me as interesting.
It’s not the study itself. From what the press accounts indicate, Morningstar compared the performance of 1-star funds with that of 5-star funds over the five-year period from 2005-March 2010. The conclusion?–in a majority of cases, an investor who chose funds that charged the lowest fees would have done better than one who used the Morningstar stars.
Although Morningstar has skillfully build a business that generates about $500 million in annual revenue from its star ratings, that fact that they may not have predictive value should come as no surprise. The company itself is careful not to claim that they do. And there have been academic studies from time to time that have raised the same issue. Nevertheless, it’s a powerful psychological fact that when faced with highly complex decisions, people are invariably drawn to mechanisms that seem to distill the decision down to a small number of easily understood choices–like “Do I want one star or five?”
What did I find striking?
–the WSJ story notes that 1-star international equity funds outperformed 5-star funds over the study period. Despite this, just about half of the 1-star funds were closed down during the half decade. Not only that, but the best performing funds appear to have been the ones that shut their doors. According the WSJ, the performance situation is reversed when considering funds that survived the entire time period. 5-star survivors outdistanced 1-star survivors.
Why would a fund company shut down a fund that’s outperforming? Because it can’t get anyone to buy shares. Why would that be? My bet is that good performance is not enough to overcome the stigma of a low star rating. To me this illustrates how powerful Morningstar has become in individual investor behavior.
–as presented in the WSJ, this is a pretty weird study. Morningstar has over 25 years of data on mutual funds. Why choose a five-year-and-three-month period? It should be very simple to see if the same patterns hold over longer time frames. Did Morningstar look? If so, what did it find? How did the 2- 3- and 4-star funds, which represent the large bulk of the funds rated, fare? Did the lowest-cost 5-star funds outperform the highest-cost funds?
Anyway, there are lots of questions the WSJ could have asked that could have provided analysis and insight. The fact that it didn’t shows what the WSJ has become over the last few years.