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Morningstar Stars: Are Mutual Fund Star Ratings Any Use?

Last week, I had the opportunity to attend the 2010 Morningstar Investment Conference.

During a panel conversation with four top Morningstar researchers, the moderator asked a question about the studies that are done from time to time, which tend to show that Morningstar’s star ratings don’t work all that well as predictors of future performance.

Don Phillips, President of Fund Research at Morningstar, had a great reply:

“The star rating is a grade on past performance. It’s an achievement test, not an aptitude test…We never claim that they predict the future.”

Pretty straightforward answer, no? The star ratings aren’t even intended to predict future performance. They’re simply a calculation based on how each fund’s risk-adjusted return has compared to that of its peers (with a very heavy emphasis on the most recent 3 years of performance).

That, combined with the fact that there are more successful predictors of performance available (i.e., expense ratios), leads to one obvious conclusion: Don’t base your fund picks on how many stars they have.

It also leaves me with a question: What good are the star ratings if they’re not useful for picking funds?

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Comments

  1. If that is the case with the star ratings, so be it. But they should at least make an attempt to boldly disclose in every page where the star ratings are shown, saying that they are based on past performance. I doubt they would be that candid.

    “The star rating is a grade on past performance. It’s an achievement test, not an aptitude test…We never claim that they predict the future.” – Well, then, display that conspicuously on your website, Mr.Don. Its just plain common sense now, isnt it

  2. “Well, then, display that conspicuously on your website, Mr.Don.”

    I agree that a more conspicuous statement about the intention of the star ratings would be helpful.

    I have no data other than anecdotal evidence, but I bet if you polled 100 investors, more than half would say that the express purpose of star ratings is to guess which funds will do well in the future.

  3. It’s pure marketing hype, and too conspicuous of a disclaimer would cost them money. When a fund gets four or five stars, the distribution arm of the fund company pays for permission to put those stars on their marketing materials. Why? Because many brokers have been programed to say something like, “legally, we can’t claim any link to past performance, but I’ve been at this a long time and am a trained professional, blah, blah, blah, and I know there really is a connection. “

  4. The efficient market evidence is so pervasive; just stick with index funds, save time and do better than most. Regards, Barb

  5. Mike thanks for posting this! I’ve always wondered what they represented myself, but never went through the effort to figure out what they meant. I’m afraid to admit that I’ve used them in the past to decide which funds were better than others. How naive of me! Thank you for point this out, great tip!

  6. “”I’ve always wondered what they represented myself, but never went through the effort to figure out what they meant”””

    That is what exactly works in favor of morningstar and many many folks including me have done that…Shame on their business practice..

  7. I’m hoping you can post some hard numbers, I would love to see by just how much lower expense ratios do better the 4 and 5 start funds.

    On the second note, I’ve never liked morning star ratings. It’s a perception scam that cons the majority of people to think that 4 and 5 star funds will outperform the market without ever saying it will.

    A good site to quickly look at how a fund has done in the past is fundalarm.com. Same basis as morningstar but better because it tells you why.

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