The value of Morningstar ratings

Investment research has evolved over the years, giving investors and wealth managers a plethora of tools to assess various investment options. But how can we determine which research providers and their respective tools are truly adding value versus merely providing superfluous data?

In this article, we assess the utility of Morningstar’s flagship analysis and star rating system.

What are Morningstar ratings?

Morningstar is a U.S. financial services company that provides a range of investment research and investment management services. A signature component of Morningstar’s investment research services is its proprietary fund star rating system.

Essentially, Morningstar rates ETFs and mutual funds from 1 to 5 stars based on how well the funds have performed, after adjusting for expenses and risk, relative to similar ETFs and mutual funds.

Morningstar gauges a fund’s risk by calculating a risk score for each fund, primarily focused on a fund’s historic volatility. Within each Morningstar category, the top 10% of ETFs and mutual funds in their respective peer group receive 5 stars, the next 22.5% receive 4 stars, the middle 35% receive 3 stars, the next 22.5% receive 2 stars and the bottom 10% receive 1 star. ETFs and mutual funds are rated for trailing three-, five- and 10-year time periods, and these ratings are aggregated to produce an overall rating. Ratings are recalculated each month.

Morningstar describes their ratings as fully objective, based solely on a mathematical evaluation of the assessed funds.1 Even though ratings are a useful tool for identifying funds worthy of further research, the evaluations shouldn’t be considered buy or sell signals.

Why are Morningstar ratings valuable?

Morningstar ratings provide a snapshot of a fund’s historical risk-adjusted performance. The key word here is historical, and as Morningstar points out, a fund’s past performance should not be projected to persist in future time periods. Rather, Morningstar ratings simply provide an assessment of how a respective fund has historically performed against its peer group.

The Morningstar rating system concisely categorizes and summarizes most of the ETF and mutual fund universe’s historical performance in an easily digestible and understandable manner. Wealth managers and investors are tasked with analyzing and using this data as they see fit.

What are the flaws and limitations of Morningstar ratings?

Before we dig into the details of Morningstar ratings’ chief flaws and limitations, let’s repeat one crucial point. Assuming all of Morningstar’s data and peer group categorization are completely accurate — we’ll discuss why this is a poor assumption in the next section — historical risk-adjusted outperformance or underperformance should not be expected to persist.

A fund that has earned a 5-star rating should not be expected to earn and maintain that 5-star rating in the forthcoming three-, five- and 10-year time periods. In fact, The Wall Street Journal examined Morningstar ratings by analyzing the historical performance of thousands of funds since 2003, shortly after Morningstar rolled out its flagship rating system. Funds that earned high star ratings for strong historical risk-adjusted performance largely failed to outperform against peers in subsequent periods.

As The Wall Street Journal points out, “Of funds awarded a coveted five-star overall rating, only 12% did well enough over the next five years to earn a top rating for that period; 10% performed so poorly they were branded with a rock-bottom one-star rating. Their average Morningstar rating for the following five years was three stars — in other words, halfway between the top and the bottom. When funds picked up a fifth star for the first time during the period included in the Journal’s analysis, half of them held on to it for just three months before their performance and rating weakened.”2

Thus, investors should keep in mind that Morningstar ratings are backward-looking, and past performance often does not persist in the future.

Does Morningstar have a data integrity problem?

A potential critical flaw in Morningstar’s rating system that has been highly debated recently revolves around Morningstar’s data integrity, specifically as it relates to fixed income mutual fund holdings.

In a paper written in 2020 by academics Huaizhi Chen, Lauren Cohen and Umit G. Gurun, they provide evidence that some bond fund managers misclassify their holdings that are ultimately provided to investment information intermediaries, particularly Morningstar. The paper notes, “Many funds report more investment grade assets than are actually held in their portfolios to important information intermediaries, making these funds appear significantly less risky. This results in pervasive misclassification across the universe of U.S. fixed income mutual funds. The problem is widespread — resulting in up to 31.4% of funds being misclassified with safer profiles, when compared against their true, publicly reported holdings.”3

The paper continues, “Misclassified funds — i.e., those that hold risky bonds, but claim to hold safer bonds — appear to on-average outperform the low-risk funds in their peer groups. Within category groups, misclassified funds moreover receive higher Morningstar Ratings (significantly more Morningstar Stars) and higher investor flows due to this perceived on-average outperformance.”4

Essentially, for these misclassified funds, the Morningstar rating may be useless, and even misleading, given that the underlying data to analyze the respective risk-adjusted performance may be flawed.

This data integrity issue results in the possibility that a bond mutual fund’s past risk-adjusted performance is erroneous, as well as the possibility that the respective fund is not compared to the appropriate peer group.

The fact that many investors allocate to fixed income for income and stability only compounds this potential problem. If an investor is solely using Morningstar’s data when assessing a misclassified fund and includes the misclassified fund in their portfolio, their asset allocation may be riskier than perceived and riskier than optimal.

The authors of the paper compared bond mutual fund companies’ summary holdings reports, which Morningstar relies on in its analysis, to the actual holdings reported to the U.S. Securities and Exchange Commission (SEC). The paper found that 100% of the apparent outperformance of misclassified funds came from the flawed comparison to a less risky peer group. A potentially significant problem, indeed.

Is Morningstar’s rating system too narrow?

Lastly, as we’ve touched on, Morningstar star ratings focus solely on risk-adjusted performance. The star ratings alone ignore other key tenants of investment research, such as the consistency and quality of a fund’s parent, people and process, as well as the fund’s cost.

How should investors use Morningstar ratings?

While Morningstar star ratings certainly have their limitations, they are helpful in analyzing a fund’s risk-adjusted performance track record. Investors should always keep in mind that past performance often does not persist, as well as note the possible data integrity issues for fixed income mutual funds. To determine a fund’s prospects for long-term success, investors should also focus on a respective fund’s parent, people, cost and process.

For parent, how well-managed is the fund company overall? Does the company have a strong ethical track record with a healthy investment culture that puts the long-term interests of investors front and center?

Similarly, do the people managing and supporting the fund have experience, expertise and longevity? Are their interests aligned with shareholders, and is the team’s bench deep enough to reduce any key-person risk? These are essential questions to focus on when assessing the parent and people managing the fund.

A fund’s expense ratio is also crucial to evaluate, as costs are a component that investors can control. Costs have proven to be a strong indicator of future fund performance, so analyzing a fund’s comprehensive fees relative to peers is essential.

Last but not least, a fund’s investment process is critical to analyze. It’s important to research the consistency and comparative advantage of a fund’s investment strategy.

Morningstar star ratings won’t necessarily directly shed light on these other important components of investment fund research. While public investment information providers such as Morningstar play a valuable role in the process, their ratings should only be one consideration in a holistic review of any potential investment option.

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The value of Morningstar ratings

Kevin Calhoun

CFA® | Investment Associate

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The value of Morningstar ratings

time to read: 6 min