The Utility of Grades

In the mid-1980s, as the number of U.S.mutual funds swelled past 1,000, it became clearthat an individual investor or financialadvisor could no longer perform due diligenceon all the available choices. Some sortof screen or means of grading the prospects hadbecome essential. Joe Mansueto, publisherof the newly launched Mutual Fund Sourcebook,responded to this challenge by introducingthe Morningstar fund ratings ranging from 1 to 5stars to help investors more quickly identifyfunds with better records.

Joe borrowed from the academic thinking of thetime, which argued that funds should not beevaluated over quarters or calendar years, as wasthen the fashion, but instead should beassessed based on longer periods. Joe set threeyears as the minimum evaluation periodand gave greater weight to the five- and 10-yearrecords when available. Academics alsourged investors to consider the risk that funds tookto achieve their gains and the costs that theyimposed on investors. Costs were a significantand challenging thing for investors to grasp,as front-end sales charges were then frequently ashigh as 8.5% and fees had recently beencomplicated by the introduction of deferred loadsand 12b-1 fees. In addition, some fundscharged loads for the reinvestment of incomedistributions, while others did not. At thetime, many performance evaluations simplyignored most costs and did nothing to address therisks a fund took.

The star rating thus represented a considerableleap forward. Adding cost and risk to thenotoriously fickle element of performance wasa major improvement, as costs and riskcould be better taken from the past and projectedinto the future. High-cost funds don’tsuddenly become cheap. Managers who arenaturally risk-averse don’t randomly start buyingdicier companies or taking big sector betsor stretching for yield. Risk, unlike performance,is somewhat a matter of choice. Whilethe star ratings didn’t speak to the people behindthe performance or their process (Morningstarwould address those concerns later as it foughtfor the disclosure of manager names andincentives), the stars did present a more intelligentstarting point than the system of short-term, rawperformance screens they replaced.

From their introduction, Morningstar displayedthe star ratings in context with scores of other datapoints. They were a reasonable place to begina search, as it obviously makes more sense tofocus on funds that have demonstrated success—and then to dig deeper to see if there is reasonto expect the success to continue—than itdoes to concentrate on funds with poor performance,high costs, and high volatility onthe hope that they may correct those flaws.Moreover, Morningstar consistently spoke ofthe stars in sober terms, trying candidly to describeboth their advantages and their limitations.The stars are a starting point, not a conclusion—a grade, not a prediction.

Nevertheless, some observers insist on evaluatingthe stars as predictions. Multiple popularand academic studies explore the predictive powerof the stars. Most find the stars to be preciselywhat Morningstar itself has long said—the starsare mildly predictive. In 2016, we removedthe load adjustment from the calculation, asempirical data suggested that few investors werepaying these loads anymore. But becauselong-term returns and ongoing expenses havea negative correlation, the stars still effectively tiltinvestors away from high-expense funds,and they modestly up the odds of good investoroutcomes. Not bad for a first-stage screen.Still, it’s fashionable for advisors to disparage thestars, often offering their preferred alternativesas a better path. “Just buy low-cost index funds”and “just buy funds from a favored providerlike DFA or American Funds” are popular advisorrefrains. Invariably, however, these alternativeapproaches correlate strongly with what the starsalready tell investors. Low-cost, broad-marketindex funds have consistently held above-averagestar ratings, as have the DFA and AmericanFunds groups. The stars can hardly be misleadinginvestors if they suggest the same conclusionstheir critics urge. I’ve met many advisorswho deride the stars, but I’ve yet to meet onewhose own recommendations don’t skewtoward higher star ratings. Few if any people buildconsistently winning portfolios out of 1- and2-star funds.

Moreover, these critics overlook perhaps the stars’greatest benefit. The stars, by rewarding betterlong-term, risk-adjusted performance, encouragemore prudent behavior among managers.They create precisely the incentives that a rationalinvestor would desire their manager to have—a focus on the long term, pressure to lower costs,and disincentives to take wild risks.

Schools don’t assign grades to help futureemployers identify the best hires; schoolsassign grades to motivate better student behavior.So, too, do the stars discipline managersto behave in a more shareholder-friendlymanner. In effect, the stars shift performanceevaluation from something fund managerscrave—a tool to promote short-term sales whilecamouflaging costs and risks—into somethingthat investors and their advisors want—incentives for greater prudence and predictabilityin the management of their assets. That’s a5-star outcome.

This article originally appeared in the April/May 2018 issue of Morningstar magazine. To learn more about Morningstar magazine, please visit our corporate website.