Most Popular ArticlesDecember 8, 2009
Significant findings for the raw returns include:
• US equity funds, which had monotonic results in 2007, are no longer monotonic. Funds rated 2-stars outperformed those rated 3-stars. In virtually all cases, the correlation between adding a star and improving performance declined from the previous study. This time, only 52.1% of one-star upgrades yielded improvement, down from 53.5% in 2007. US Equities were the most robust category in the current study; results for the other four categories deteriorated more significantly.
• International funds, which were the only non-monotonic category in the previous study, were again non-monotonic. The average likelihood of one-star improvement declined from 51.2% to 50.4%.
- Balanced funds, which were monotonic in the original study, are no longer monotonic – 5-star funds underperformed 4-star funds and 4-star funds underperformed 3-star funds. The average one-star improvement declined significantly from 58.5% to 49.2%. (A value below 50% indicates that advisors would be better off with a fund rated one star lower.)
- Taxable bond funds remained monotonic, but the average one-star improvement declined from 58.3% to 52.7%.
- Municipal bond funds are no longer monotonic. Notably, the probability of a 5-star fund outperforming a 4-star fund declined from 61.5% to 34.2%. The odds were nearly two-to-one that a 4-star fund would outperform a 5-star fund. By the same token, a 4-star muni fund will beat a 2-star in the same category 63.6% of the time, but a 1-star only 55.5% as often. The average one-star improvement declined from 61.2% to 48.6%
Funds given 5 stars did not perform well in a number of categories. Among muni bond, taxable bond and international funds, 5-star funds had the lowest raw returns of any star category.
The one-star improvement across all five fund categories is now 50.6%. Advisors might as well flip a coin to decide whether to move to a fund with a rating that is one star higher.
These results are for raw returns. Risk-adjusted returns provide a very slight improvement – the one-star improvement across all five categories 50.7%, but our overall conclusions remain.
In his analysis, Russel Kinnel of Morningstar states, “In short, the star rating is a backward-looking measure of past performance. What it is not is a forward-looking measure of fundamentals.”
We concur that the ratings are not an effective forward-looking measure, but that is not how they are used in the industry. By calling this calculation a rating, Morningstar imparts at least the implicit endorsement of higher-rated funds and an expectation that their relative performance advantage will endure.
If Morningstar truly believes that its ratings lack forward-looking value, then they should rename them “Historical Performance Measures” or something to that effect. In this case, however, advisors would be better served by looking at underlying data – the three-, five- and 10-year performance numbers used in Morningstar’s calculation. Combining these numbers into a single star rating – or historical performance measure – merely obscures the value of the underlying data.
Caveats
As we noted in our original study, there are a number of important caveats that apply to our results:
- This analysis does not take into account survivorship. As we know from the M-G study, approximately 20% of funds that existed when the three-year period began will be merge or be terminated by the end of the period, and they are excluded from this study. This is much more likely to occur with lower rated funds (specifically 1- and 2-star funds), since fund companies are less likely to merge or terminate a higher-rated fund. As a result, we can expect that the probabilities below understate the true probabilities for funds outperforming these lower rated funds. But this is only conjecture and would need to be verified by additional data analysis.
- Morningstar’s assignment of ratings takes into account the effect of sales loads, but the rate of return calculations below (both total rate of return and risk-adjusted rate of return) do not reflect sales loads. The universe of funds used includes load and no-load funds. The inclusion of loads would reduce the performance of some funds. If Morningstar had included the effect of star ratings on the total return and risk-adjusted return calculations, the results would have been better for the predictive value of the rating, as load funds have lower overall ratings than no-load funds. So, in that sense, this study is a conservative look at the predictive value of the ratings because, to the extent that any loads are paid, the ratings would perform better. Ideally, from an advisor’s perspective, we would like to see this analysis done with a universe of no-load or load-waived funds.
- This analysis does not use the risk-adjustment metrics employed by M-G (alpha and Sharpe Ratio). Ideally, advisors would like to know the probabilities of fund outperformance based on alpha (i.e., what is the probability of a fund with rating x outperforming a fund with rating y on a risk-adjusted basis?)
David Raileanu assisted in the research and writing of this article.
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