Wednesday, November 9th, 2011

Should you find yourself reading the sort of publication that is tailored to investment advisors or do-it-yourselfers, you’ll see lots of these:


In fact, I have in front of me a single page (standard magazine size) that has no less than five hundred six of the things, arrayed for the purpose of dazzling the viewer into thinking that if there’s that many stars in their firmament, one particular firm must surely approximate investment heaven.

The stars are, of course, awarded by Morningstar.  Taking a break from an ongoing series on investment styles,the research puzzle | This PDF updates that series as it progresses. it’s time to think about a classic case of ratings turning into something they are not meant to be.

The Morningstar system is one of the great marketing constructs of all time.  But what do those five-pointed symbols mean?

They are, by definition, a look backward at the performance of a mutual fund.Morningstar also uses stars for other vehicles, some of which do not involve past performance.  Its ratings of individual stocks, for example, are based upon the relationship of market price to the firm’s estimate of intrinsic value, as adjusted by other factors. The ad with all the stars — like all such ads — includes a statement that, “Past performance is no guarantee of future returns.”  The lawyers make them say that, but the firms that buy the ads intend for you to think the opposite.

The funds and their managers that reach the pinnacle are five-star generals, of a sort, having earned the awards from previous market campaigns that may or may not say anything about their ability to wage battle under the changing conditions of investment warfare.  Whether you think the Morningstar ratings matter or not, matter they do.  And those stars are but one aspect of this market truth:  Because of the expense and difficulty of good due diligence, there is a chain of reliance that leads to smart, sophisticated people depending on the evaluations of others.  Yet, I’m often surprised how little the users know about what the raters do and how they do it.

The proximate cause of these musings is the upcoming roll-out of the Morningstar Analyst Rating for funds.Morningstar | Here is an explanation from the firm; take a look at the comments as well. The firm intends to provide ratings that look forward, with a new system that represents analyses based upon five Ps:  people, process, parent, price, and performance.  Whether it is successful in identifying the best funds prospectively, it is notable that it would even attempt to do so given the power of its star ratings in the marketplace.

I expected the new system to have spawned many more articles about what its introduction means.  Millions of dollars are spent by mutual fund firms to deliver stars to your eyes — what will be the effect of a bold initiative that reminds us of the fact that the existing system looks backward, reinforcing the tendency of investors to chase and thereby to lose?  And what of investor allocations to funds that have followed the the addition and subtraction of stars?SSRN | Here’s an example of the research that’s been done on this topic. Will they start to follow the analyst ratings instead?  Or will it be business as usual?

The stars are most powerful retail investment ratings scheme extant, and Morningstar is in effect competing against its own dominance by introducing the analyst ratings.  Perhaps it got tired of seeing firms use the stars in ways that end up harming the investors that are charmed by them.

Morningstar has its work cut out for it with this new endeavor, but the firm should be admired for trying to change a game that it controls.  I’m sure that fund companies will still sprinkle stardust around indiscriminately, but maybe advisors and investors will see that it’s more sawdust than anything else.