THE
WALL STREET JOURNAL.
Investors everywhere think a 5-star rating from Morningstar means a
mutual fund will be a top performer—it doesn’t
By Kirsten Grind, Tom McGinty and Sarah Krouse
Millions of people trust
Morningstar Inc. to help them decide where
to put their money.
From pension funds to endowments to
financial advisers to individuals, investors rely on Morningstar’s star ratings
to help divide $16 trillion among America’s mutual funds, in much the way
shoppers use Amazon’s ratings to pick products. A lot of these investors, and
the people paid to guide them, take for granted that the number of stars awarded
to a mutual fund is a good guide to its future performance.
By and large, it isn’t.
The Wall Street Journal tested
Morningstar’s ratings by examining the performance of thousands of funds dating
back to 2003, shortly after the company began its current system. Funds that
earned high star ratings attracted the vast majority of investor dollars. Most
of them failed to perform.
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.
The falloff in performance was even
more dramatic for domestic stock funds, the largest category of U.S. funds by
assets.
Billions of investor dollars hang in
the balance. Nearly every asset manager in the world pays Morningstar for data
services. Some 250,000 financial advisers rely on Morningstar’s data, services
or ratings, according to the firm. That means Morningstar’s analysis and ratings
influence investment decisions for a vast landscape of retirement plans and
brokerage accounts.
Morningstar’s reach is so pervasive
that the ecosystem for buying and selling mutual funds revolves around it. Fund
companies heavily advertise their star ratings. Money typically pours into funds
after they receive a five-star rating from Morningstar, the Journal found. It
flows out if they lose stars.
There is no question that
Morningstar has greatly improved the transparency and rigor of data on mutual
funds’ holdings and performance, making it easier for individual investors to
compare funds.
Morningstar says it has never
claimed its star ratings suggest how funds will perform in the future. The star
system is strictly backward-looking, assessing past performance, the firm says.
“We have always been very clear that it’s not intended to predict future
performance,” the company said in a written statement.
“The star rating works well when
it’s used as intended: as a first-stage screen that helps identify lower-cost,
lower-risk funds with good long-term performance,” Morningstar said. “It is not
meant to be used in isolation or as a predictive measure. Reversion to the mean
is a powerful force that can affect any investment vehicle.”
![](WSJ%2020171025%20HowFunds-a%20h23.png) |
![](WSJ%2020171025%20HowFunds-b%20h23.png) |
Notes:
Year zero represents the initial overall rating of funds. Other points on
chart are their average star ratings for the following three, five or ten
years. Funds rated by Morningstar can have up to four ratings: a
three-year rating, a five-year rating, a 10-year rating, and an overall
rating that is based on a combination of the others.
Read the methodology. |
The firm sends conflicting signals
about the star ratings’ predictiveness. A study published by Morningstar last
month said the stars point investors to funds “likelier to outperform in the
future.”
Morningstar founder Joe Mansueto
said in an interview that the firm’s analysis of past ratings found “some modest
predictive value.” Chief Executive Kunal Kapoor, in another interview, called
the star system “a better predictor than it ever has been.”
In its written statement to the
Journal, Morningstar said its analysis has found “the Star Rating is moderately
predictive,” which “conforms to what we’d expect of a backward-looking, entirely
quantitative measure.”
The Journal’s analysis found that
most five-star funds perform somewhat better than lower-rated ones, yet on the
average, five-star funds eventually turn into merely ordinary performers.
Inside Morningstar, some employees
have expressed discomfort about how much investors rely on the ratings. Stephen
Wendel, head of behavioral science at the Chicago-based firm, wrote in the
June/July issue of Morningstar magazine that part of his job was “examining
whether we are contributing to abuses in the industry,” and said: “Morningstar’s
star ratings for funds are clearly used in the industry to imply that funds that
performed well in the past will do so in the future.”
He added, “That needs to change.”
Morningstar’s Mr. Mansueto, 61 years
old, said the star rating system “is a way to whittle down a big universe into
something more manageable.” The firm said it has worked to make investors
understand the star ratings should be just a starting point for their research.
Since 2011, Morningstar has had a
second rating system, lesser known and of limited scope, that includes analysts’
opinions. Unlike the star ratings, it is designed to be forward-looking,
Morningstar says. In this system, too, the Journal found the performance of
funds rated high, low and in between tended to converge after several years. In
addition, the Journal found Morningstar only rarely gave funds the lowest
analyst rating, “negative.”
Mr. Mansueto, growing up in suburban
Chicago, sold lemonade by the roadside before moving up to Christmas trees. At
the University of Chicago, he and a roommate sold chips and soda and advertised
by hanging posters for the “Room 607 Soda Service.” He also made his first
mutual-fund investment, with $250 from a restaurant job.
After college, he and the
ex-roommate, Kurt Hanson, started a business that provided market research for
radio stations. It surveyed listeners and created a sheet of charts detailing
their behavior. Mr. Mansueto then got a job as a financial analyst at Harris
Associates LP, a Chicago money manager.
Mutual funds were proliferating, and
a few fund managers were becoming stars, such as John Templeton and Peter Lynch.
Funds didn’t give much information about themselves, and what they provided was
opaque to nonprofessionals. Mr. Mansueto told a colleague he wanted to start a
fund newsletter in the mold of the radio-station fact sheets.
The colleague, Ralph Wanger,
cautioned that financial newsletters didn’t have a record of success. “That
turned out to be the dumbest...thing I ever said,” he recalls. “What I meant to
say was, ‘Joe, that’s the best idea I’ve ever heard—how about I quit and we go
50-50?’ ”
Mr. Mansueto launched Morningstar
from his one-bedroom apartment in 1984 with $80,000, taking the name from the
ending of Thoreau’s “Walden”: “The sun is but a morning star.”
He later spent $50,000 to hire Paul
Rand, the noted designer of
IBM’s logo, who created a signature red
font consisting of tall letters with an “O” looking like a rising sun. With
reports obtained from fund companies, Mr. Mansueto laid out data points so they
were easy to read, and advertised his reports in Barron’s.
When BusinessWeek later asked him to
devise rankings for an issue devoted to mutual funds, Mr. Mansueto began work on
what would become his five-star rating system. He toyed with using symbols
suggesting little bags of gold before deciding on stars.
Since then, assets invested in
U.S.-based mutual funds have multiplied more than forty-fold. Morningstar rode
the wave and went public in 2005.
Today, investors descend on Chicago
for Morningstar’s annual conferences, a pilgrimage for money managers and
financial advisers hoping to gather assets. At this year’s event in April,
shirtless male acrobats cartwheeled and stood on each other’s shoulders while
financiers sipped cocktails and mingled.
Morningstar groups funds into
categories based on their investing style or area, more than 100 groups in all.
It compares funds not to all other funds, nor to the overall market, but to
other funds with the same investment focus. The top 10% of funds in each group
receive five stars, the bottom 10% get one, and the rest get two, three or four
stars.
The ratings don’t reflect raw
performance, but performance adjusted for funds’ degree of risk. To make that
calculation, Morningstar uses an algorithm Mr. Mansueto devised that reflects
the variation in funds’ month-to-month returns.
The firm rates funds on how they did
over three years—plus over five years and 10 years if they’re old enough—and
assigns them an overall rating based on the others. A fund thus could have as
many as four ratings from Morningstar, though most investors see only the
overall one. New star ratings come out each month.
Most mutual funds have multiple
“classes,” each charging a different expense fee. Since varying expenses spell
varying returns, Morningstar rates each class of each fund separately.
Its star ratings covered more than
10,800 mutual funds—and almost 39,000 share classes—during the 14 years studied
by the Journal. The only qualification to be rated is being in business three
years. The ratings include index funds, which try to mimic the performance of
markets.
(The Journal’s analysis didn’t
include exchange-traded funds, or ETFs, which trade throughout the day like a
stock and usually mirror an index. Morningstar began rating ETFs alongside
ordinary mutual funds late last year, after the period covered by the Journal’s
analysis.)
Going back to 2003, the Journal
examined the rating of every investment class of every fund, in every month, and
how these changed over time—some three million records in all. (Read
the methodology.)
The Journal also reviewed
retirement-plan data, fund ads and regulatory filings, and interviewed dozens of
current and former Morningstar employees, fund officials, financial advisers and
investors.
For funds that had an overall
five-star rating at any point, the Journal found that 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.
The findings were especially stark
among U.S.-based domestic equity funds. Of those that merited the five-star
badge, a mere 10% earned five stars for their performance over the following
three years. Only 7% merited five stars for the following five years, and 6% did
for 10 years.
For all of the measured
periods—three, five and 10 years—five-star domestic equity funds were more
likely to turn in a one-star performance than a top one.
That means a five-star rating for
the equity funds was no more an omen of success than it was one of failure.
Morningstar’s ratings of
taxable-bond funds, which include corporate bonds and Treasurys, proved a little
more indicative of future performance. Of five-star bond funds, about 16% turned
in a five-star performance over the next five years.
Still, 8% of the five-star
taxable-bond funds performed poorly enough to merit only one star.
Hickory Hills, Ill., not far from
Morningstar’s Chicago headquarters, has a small pension fund for about 50 active
and retired police officers. In 2011, it moved about $2.1 million into the
Nuveen Santa Barbara Dividend Growth Fund, which had a five-star Morningstar
rating.
The pension board paid close heed to
star ratings. “Our brokers thought it was one of the best measurements we had
available to decide whether the fund is worth investing in,” said board
secretary Mary McDonald, referring to brokers from
Morgan Stanley.
The fund had beaten 95% of others in
Morningstar’s “large blend” category—funds that buy large-company stocks using a
blend of what investors call a “value” strategy and a “growth” strategy.
The following year, the fund beat
only 26% of similar funds, and in 2013 just 11%.
![](WSJ%2020171025%20Nuveen1b%20x19.png) |
![](WSJ%2020171025%20Nuveen1a%20x21.png) |
Notes:
Class I share class. Funds rated by Morningstar can have up to four
ratings: a three-year rating, a five-year rating, a 10-year rating, and an
overall rating that is based on a combination of the others.
Read the methodology. |
The president of the Santa Barbara
fund family, John Gomez, attributed the Dividend Growth fund’s performance to
its focus on stocks with growing dividends, not just the highest-yielding ones.
The Hickory Hills board pulled $1.2
million from the fund in 2014, and in early 2016 it took out $750,000 more. It
has since switched to a local broker, in part because of Morgan Stanley’s
reliance on Morningstar ratings, said David Wetherald, a police officer who is
also the pension board’s president.
The experience was frustrating
because “we rely a lot on the financial people. We’re not completely blind and
naive, but we’re smart enough to know that this is what they do,” Mr. Wetherald
said.
Morgan Stanley declined to comment.
Morningstar said its five-star
rating of Nuveen Santa Barbara Dividend Growth in 2011 “was an accurate
historical grade on the fund. It was not intended as or presented as a
conclusion as to what they should do.”
Morningstar also said this type of
fund generally did poorly after 2011. The example “presents an underperforming
fund in a badly underperforming category as if it’s representative of the full
rating set, which it’s not,” the firm said.
The Journal’s analysis found that
investors put new money into five-star-rated funds in 69% of the months they
held that rating, compared with 29% for one-star funds. The Hickory Hills
investment was part of $184 million investors put in the Santa Barbara fund in
2011 when it had five stars.
Morningstar acknowledged its ratings
can influence demand, though Mr. Mansueto says he believes investors typically
move money mainly based on a fund’s performance, not its star rating.
![](WSJ%2020171025%20MoneyInFlow-a%20x21.png) |
![](WSJ%2020171025%20MoneyInFlow-b%20x21.png) |
Note:
Funds rated by Morningstar can have up to four ratings: a three-year
rating, a five-year rating, a 10-year rating, and an overall rating that
is based on a combination of the others.
Read the methodology. |
The Journal found more than a dozen
cases where well-performing funds attracted few investors until they won a fifth
Morningstar star.
Tiny Buffalo Emerging Opportunities
Fund saw little interest despite beating many similarly focused funds over three
years, including gaining 24% in 2012. After it got a fifth star from Morningstar
in spring 2013, hundreds of millions came in, quadrupling assets to above $400
million in five months.
The small management team in
Mission, Kan., closed the fund to new investors six months later, a step
managers sometimes take when given more cash than they feel they can invest. The
Journal found many instances of funds closing after an influx that followed a
high star rating.
At Buffalo Emerging Opportunities
Fund, fortunes soon reversed. In 2014 it lost more than 7% and trailed about 95%
of other funds focused on growing small companies. Over the next two years its
Morningstar rating fell to two stars and its assets plunged to less than $100
million.
Buffalo Funds declined to comment.
![](WSJ%2020171025%20Buffalo-b%20h22.png) |
![](WSJ%2020171025%20Buffalo-a%20h22.png) |
Note:
Funds rated by Morningstar can have up to four ratings: a three-year
rating, a five-year rating, a 10-year rating, and an overall rating that
is based on a combination of the others.
Read the methodology. |
Inflows sparked by high star ratings
are especially important for managers of actively managed funds now that more
investors have migrated to passive ones that just try to match an index. On
calls with securities analysts, fund-company chiefs often trumpet how much of
their asset total is in four- and five-star funds, as a sign of the companies’
ability to attract cash.
From his office park in
Mechanicsburg, Pa., financial adviser Donald DeMuth starts each workday by
logging onto Morningstar Office, which helps him organize client portfolios. He
also uses Morningstar data to check on fund performance and details such as how
rapidly a fund’s portfolio turns over.
Mr. DeMuth, 66, has used Morningstar
so long he can’t remember when he started. “With rare exception, we would want a
fund to have five stars,” he said.
In early 2012 he put some of his
clients’ money in a fund called Permanent Portfolio when it had a five-star
Morningstar rating. The fund invests across an array of assets, including gold
and silver.
Its performance had already started
to slip. By the end of 2012, it was 5 percentage points behind its Morningstar
category benchmark, the “Morningstar Moderate Target Risk,” which is a mix of
global bonds and global stocks.
Mr. DeMuth moved his clients out in
the fall of 2013, a year when the fund trailed that benchmark by 16 percentage
points. At the end of 2013, Morningstar gave the fund a one-star rating for its
performance over the prior three years.
![](WSJ%2020171025%20Permanent-b%20h19.png) |
![](WSJ%2020171025%20Permanent-a%20h19.png) |
Notes:
Class I share class. Funds rated by Morningstar can have up to four
ratings: a three-year rating, a five-year rating, a 10-year rating, and an
overall rating that is based on a combination of the others.
Read the methodology. |
Client David Peterseim, a
55-year-old retired surgeon in Charleston, S.C., said he was relieved the
financial adviser got out. He was disappointed “Morningstar didn’t have some
semblance to reality,” Dr. Peterseim said.
Michael Cuggino, president of the
San Francisco-based family of Permanent funds, said Permanent Portfolio’s
performance suffered as the price of gold and silver dropped.
Morningstar said Permanent Portfolio
was an “outlier” that “was designed as an inflation hedge; when precious metals
are in favor, it will score well, and when they’re not, this fund won’t do
well.” Major rallies in gold and silver ended in 2011, shortly before Mr. DeMuth
invested.
Other industry practices show how
much Wall Street’s system for buying and selling mutual funds revolves around
Morningstar ratings. Brokerage firms recommend high-stars funds to their
networks of tens of thousands of financial advisers, and those brokers in turn
put clients’ money in the funds. Large fund firms such as Fidelity Investments
and
T. Rowe Price Group Inc. allow investors to
filter out funds with low star ratings on their websites.
Current and former Morningstar
employees said some advisers use the ratings as a crutch.
“It’s a cover-your-ass type of
service,” says Samuel Lee, a former strategist at Morningstar. “An adviser can
say, ‘I’m going to put you in this fund, it’s a 5-star fund,’ …and if something
goes wrong the adviser can shunt blame to Morningstar.”
Scott Jennings, a former Morgan
Stanley financial adviser, recalled struggling last year to explain to a
company’s employees which funds they should choose in their retirement plans. He
decided to keep it simple and told them, “You only have two funds rated by
Morningstar—one’s a two-star and one’s a four-star. Go with the four-star.” He
could see a look of understanding flash across their faces.
At Morgan Stanley, “Advisers get in
trouble when they go against the grain,” Mr. Jennings said. “You isolate
yourself more if you sell something else rather than just go with what research
recommends.”
Morningstar said if advisers use the
ratings this way, “this is a fault with the users of the ratings, not the
ratings.... If an advisor wants to do proper due diligence, we provide a robust
set of information.” The firm’s marketing cautions that “a high rating alone is
not a sufficient basis for investment decisions.”
Morgan Stanley declined to comment.
Fund firms often cite Morningstar
ratings in their advertising—at times even out-of-date ones. AllianceBernstein
ran an ad for nine of its funds in a spring edition of Private Wealth magazine,
citing star ratings from September 2016. Two of the funds’ ratings had fallen by
the time the ad ran. AllianceBernstein ran a similar ad with the September
ratings in a Morningstar handout at the research firm’s April conference.
A spokesman for AllianceBernstein
said it made a “human error” in two instances out of “hundreds of digital and
print ads running that quarter.”
Dallas-based Hodges Small Cap Fund’s
retail share class beat 95% of similar funds in 2010 but had less than $100
million in assets. Late in 2011 Morningstar gave it a fifth star, and everything
changed, said Craig Hodges, who manages Hodges Capital Management.
Charles Schwab put the fund on its “Schwab
Select List.” Mr. Hodges and his brother Clark decided to advertise the star
rating on a billboard in Dallas/Fort Worth airport.
Hodges Capital paid more than
$10,000 to Morningstar for the right to advertise the stars, Craig Hodges said.
By the end of 2014, assets in that fund reached about $1.6 billion, according to
Morningstar data.
![](WSJ%2020171025%20Hodges-b%20h175.png) |
![](WSJ%2020171025%20Hodges-a%20h175.png) |
Notes: Retail share class. Funds rated by Morningstar can have up to four
ratings: a three-year rating, a five-year rating, a 10-year rating, and an
overall rating that is based on a combination of the others.
Read the methodology. |
Investment giants Vanguard Group and
Fidelity Investments pay upward of $1 million a year for licensing, data and
other tools from Morningstar, said people familiar with the arrangements. It’s
unclear how much is just for advertising.
Michael Rawson, who was a
Morningstar fund analyst for six years until spring 2016, said asset managers
who pay to advertise their stars are misrepresenting their funds because the
ratings are solely backward-looking.
“We know people misuse it. If we
know people misuse it, why don’t we do something about it?” Mr. Rawson said.
Morningstar said it publishes the
ratings because it believes they have investment merit, not for financial gain.
It said its intellectual-property licensing packages, which include the stars,
contributed just 4% of revenue in 2016.
Mr. Mansueto said employees are
encouraged to debate issues related to its products, but the efficacy of its
star ratings no longer comes up internally. “This is not a hot topic or even a
cold topic at Morningstar today,” he said.
As for the Hodges Small Cap Fund,
its performance has since turned down. Its rating has fallen to two stars from
five, and assets that had soared after the top rating have dropped by more than
half.
Aware of criticism of its star
ratings, Morningstar in 2011 launched a second rating system, currently covering
26% of fund share classes, in which the firm’s analysts do a more qualitative
assessment. Unlike the star system, analysts’ ratings often refer to likely
future performance. The firm said analysts’ ratings reflect its level of
conviction that a fund will “outperform its peer group and/or relevant
benchmark.”
The analysts give funds one of three
medals—gold, silver or bronze—or a ”neutral” or “negative” rating.
The Journal examined how these funds
performed in future years, as measured in their star ratings. It found that five
years after having a gold-medal rating from Morningstar’s analysts, funds had an
average rating of 3.4 stars for that five-year period.
Silver-medal funds were rated 3.3
stars for their performance over the following five years. Bronze-medal funds
had an average rating of 3 stars. In other words, while funds rated highly by
the Morningstar analysts did better, the differences among the funds weren’t
large.
A Morningstar spokeswoman said there
was a mismatch in how the Journal evaluated the performance of analyst-rated
funds because it relied on star ratings. She said unlike analysts, the star
ratings take into account a “load”—a sales fee—that some funds have.
The Journal analysis also found
Morningstar analysts’ ratings of funds were overwhelmingly positive. From
November 2011 through August 2017, the firm gave analyst ratings to about 9,200
fund share classes. Just 421, or 5%, received negative reviews. At the end of
August, only 1% did.
Mr. Mansueto said analysts tend to
choose better funds to examine, since they can’t review them all. “Investors
want to know what funds they should be investing in,” Mr. Mansueto said. “They
don’t care so much about what the terrible funds are.”
Morningstar recently started a third
“quantitative ratings” system that it says applies analyst screening to a
broader universe of funds. This one is likely to include more negative ratings,
executives said.
J.P. Morgan Chase
& Co. is among asset managers that regularly send portfolio managers to talk to
Morningstar analysts about the merits of their funds.
BlackRock Inc. has a team that works to
persuade Morningstar analysts of the merits of various funds, according to
people familiar with the matter.
They added that BlackRock CEO
Laurence Fink met with Morningstar analysts early this year to discuss the
firm’s ratings. In May, Morningstar upgraded to positive BlackRock’s “parent
pillar” rating, an evaluation in which analysts are looking for factors
including an alignment of interests between fund shareholders and those who
manage the funds.
A BlackRock spokesman said its team
that works with research providers “is focused on providing transparency,
education and information about our products to facilitate informed decisions.”
Morningstar said BlackRock had
changed how portfolio managers were paid in a way that led to their having more
of their own money invested in BlackRock funds. “We followed the same process in
evaluating Blackrock’s standing as a parent that we do with any other firm,”
said a Morningstar spokeswoman.
Mr. Kapoor, the Morningstar CEO,
said analysts operate independently from fund companies and without influence
from management despite frequent angry calls executives must field. “We prize
our independence,” he said.
Morningstar’s application to the
Securities and Exchange Commission for permission to launch nine mutual funds of
its own has led some critics to cry conflict of interest. The Morningstar
spokeswoman said the firm is in a quiet period related to the filing,
restricting what it can say, but she said the firm’s analysts sit “in a separate
entity” from Morningstar Investment Management, which would oversee the
company’s funds.
The Journal spoke with more than
three dozen executives at asset-management firms large and small about
Morningstar. Few would go on the record.
Several years ago, some were unhappy
when Morningstar changed the way it calculates its “stewardship grade,” which is
supposed to measure the corporate culture of each fund company. Executives from
fund companies viewed the change as the latest example of Morningstar acting
unilaterally and without explaining itself.
The money managers drafted a
two-page letter to Morningstar that accused the company of “bullying” fund
companies and running a monopoly, according to people familiar with the letter.
“The nature of what we do is going
to end up alienating some portion of the industry,” said Jeffrey Ptak,
Morningstar’s global director of manager research. “That’s not something we
relish but it’s part of our job.”
When the time came for the
money-management firms to put their names to the letter, they balked. The letter
was never sent.
The
Morningstar Mirage
By
Kirsten Grind,
Tom McGinty and
Sarah Krouse
Oct. 25,
2017 11:51 a.m. ET