The Morningstar Rating Mirage
A couple weeks ago, new Relaxing Retirement members asked a very good question which prompted an important answer that I’d like to share with you. This is a very important issue to understand on many levels.
As we were reviewing their new Retirement Bucket Strategy™, they casually asked, “we assume that we’ll use 5-star rated funds to fill out our allocation” (almost assuming an affirmative answer.)
What they were referring to is Morningstar’s famous rating system for mutual and exchange traded funds which has become almost the industry standard since they began their star rating system back in the 1990s.
To their surprise, I informed them that we use Morningstar as one of our research tools for fund classifications, holdings screens, tax efficiency, fees, and stewardship, etc., but we never use their star rating system in our analysis.
There are a few reasons for this.
Influence of Allocation vs. Individual Stock Selection
First, there is significant academic evidence which suggests that allocation factors (the percentage of your holdings weighted toward equities, small companies, and low price-to-book ratio companies, etc.) have the biggest impact on long term returns as opposed to the impact of market timing and individual investment selection.
Given this, and our strongly held belief that markets are efficient, we recommend a strategically weighted asset allocation model funded by broadly diversified and cost efficient mutual and/or exchange traded index funds.
We will dive deeper into this preference and strategy in future editions, but as it relates to our member’s question, this means that, unless you have some captive limitation precluding you from doing so, we generally don’t recommend actively managed mutual and exchange traded funds with managers who attempt to use superior stock selection and market timing to “beat” their respective asset class index.
These are the funds which are trying to land on Morningstar’s Star Rating reports!
The Morningstar Mirage
If we were to recommend actively managed funds, we would still not rely on Morningstar’s famous star rating system as an indicator of superior performance in the future.
The best explanation for this came in the recently published article in the Wall Street Journal titled The Morningstar Mirage.
To summarize, every actively managed mutual fund has coveted Morningstar’s 5-star rating since they began publishing their system because they knew that deposits would come pouring into their respective funds soon after.
The star rating was earned by past (one, three, and five year) risk-adjusted performance.
And, while the age-old warning at the bottom of all published research and advertisements for mutual funds was always present, i.e. “Past performance is no guarantee of future results,” investors avoided the reality of that warning and bought into the notion that a fund which received Morningstar’s coveted 5-star rating equated to a prediction of superior future performance vs. any other alternative without a rating as high.
Given this, billions of dollars poured into 5-star funds each year.
Unfortunately, as the Wall Street Journal article illustrates in black and white multiple times, funds which received a 5-star rating very, very rarely continued to earn a 5-star rating in the future.
“Of funds with a 5-star rating, three years later, only 14% had performed at a 5-star level.”
“Of funds with a 4-star rating, three years later, 25% received only a one or two- star rating for that period.”
What all the data indicates is that receiving a 5-star rating from Morningstar is not in any way predictive of superior future results of any mutual or exchange traded fund. In fact, it’s almost the opposite!
While Morningstar is a fabulous research tool in many areas, there is no valid way to predict future performance of a manager based on their past results. Because of this, their star rating can never be used as part of our selection criteria.