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Morningstar’s Five Stars Mean Little for Performance

October 27, 2017

New analysis concludes that the popular mutual fund rankings by Morningstar have little correlation with future performance, according to the Wall Street Journal.

The paper studied Morningstar’s rankings dating back to 2003 and found that while the highest ranked funds attracted the most asset flows, “most of them failed to perform.” Out of those awarded the top ranking of five stars, just 12% performed well enough in the next five years to earn a top ranking again, according to the Journal. And 10% did so poorly over the next five years that they were given just one star, the paper reports. Highly-ranked U.S. stock funds performed even worse, according to the Journal.

The rankings assign five stars to the top 10% of funds, one star to the bottom 10% and the rest split between two-, three-, and four-star rankings, comparing funds to others with the same investment objectives across more than 100 groups, the paper explains. Instead of showing only performance, the rankings represent performance adjusted for risk, using an algorithm devised by the firm’s founder Joe Mansueto, according to the Journal.

To be included in the rankings, mutual funds must have been in business at least three years. The Journal found more than 10,800 mutual funds and close to 39,000 share classes across the 14-year period it studied. The analysis didn’t cover ETFs, which Morningstar started ranking last year.

The firm tells the Journal in a statement that its star ranking system is meant to be “strictly backward-looking” and used only as a first step to find funds with lower fees and risk and long-term performance. But the paper says Morningstar’s statements about its rankings and their relation to performance are conflicting. The Journal’s analysis concluded that while most top-ranked funds do “somewhat better” than lower-ranked ones, five-star funds on average veer toward ordinary performance.

Morningstar’s own employees have questioned whether the star ranking system contributes to abuses, according to the paper. Stephen Wendel, head of behavioral science at the company, wrote this summer in Morningstar magazine that it’s time to change the perception that star rankings imply future performance, the Journal writes.

Morningstar has included another ranking system since 2011 that also gives analysts’ opinions on the funds, which according to the company is meant to be forward-looking, the paper writes. Nonetheless, the Journal’s analysis found that few funds ever get the lowest rating through the system, and that the performance of all funds regardless of their ratings converged within several years.

By Alex Padalka
  • To read the Wall Street Journal article cited in this story, click here.