INVESTING WITH CLARITY® BLOG
The Great Mirage
February 1, 2018 1:31:23 PM
Every now and then, an article is written in the investment world that is so polarizing, it warrants a response for the engaged. The so-called “Morningstar Mirage” article that appeared in the Wall Street Journal on October 25, 2017 is such a piece. The indictment of the star-rating system pioneered by Morningstar was so stern that any asset management firm in this business worth their “salt” should be compelled to draft a response.
Our goal in this brief piece, which is fully supported by a more detailed white paper on the subject, is to bring clarity to the discussion table. Our industry loves to get its readers to grab onto a headline to created eyeballs, hoping you don’t read the entire article rather you click on a surrounding ad leading to selling you a book or a DVD when all you hoped for was an unbiased review of the data that is responsible in nature. That is what we always hope to do for our clients and readers.
Although any opinion-based article has areas that warrant critique, this article in our mind does for the most part, address the misuse of the Morningstar star rating system in a proper manner. A very good synopsis of the tenets of the article are:
- Morningstar assigns funds stars ranging from 1-5 with 5 the best furthermore using a proprietary risk-adjusted methodology.
- Many investors and advisors use the star-rating system as a guide to future performance much like professional athlete’s scoring averages.
- Factual evidence suggests otherwise, that funds with star ratings from 1-5 end up over time converging to the middle.
- This suggests that 5 and 4-star funds move down to 3-stars and funds rated 1 and 2-stars move up to 3-stars.
The authors of the article dug deeper into what actually happens to funds three years out once they are assigned a five-star rating. Astonishingly, less than 15% retain their 5-star rating. This is a total anathema to what the general public believes to be true as the flows to funds that earn their 5-star rating are much higher than those with ratings of fund that have a 1- through 4-star rating.
Amazingly, this phenomenon is not relegated just to investors. Financial advisors and investment consultants, despite the clear evidence of the faltering of 5-star funds, follow a pathway similar to that of financial advisors in that they recommend them to their clients in much higher percentage.
Like any controversial topic, there are two sides to every story. The majority of the criticism in the WSJ article is aimed at Morningstar as they received much of blame as they created monster in the laboratory. However, we would purport that culpability certainly should be assigned to investors, fund marketing companies, advisors and other fiduciaries alike as a deep dysfunctional relationship exists between Morningstar and its strategic partners as far as interpretation of its star rating system is concerned. All of the aforementioned parties have been engaged in promoting a system that is flawed at its core. As is the case where misinformation is rampant, clarity is not present.
From investors to brokers to fiduciaries, our advice is to jump off the star rating bandwagon and seek to understand the investment strategy and process of a given money manager while determining what studies suggest are truly important factors of success such as consistency and conviction of that philosophy. Knowing what you own and why you own what you own is the great elixir to oversimplified manager screening methodologies that simply don’t deliver. The old adage that a little hard work never hurt anyone certainly applies in this instance and would make all of us as Willy Wonka once said; “A little wiser for the wear.”
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