Few accolades matter as much to a mutual fund as Morningstar's five-star designation. Earning that distinction leads to outsized flows, larger management fees and improved career prospects for the fund's managers.
For investors, though, buying a five-star fund is a much less certain proposition.
Whether an investor can expect higher returns from higher rated funds is an important question. Since Morningstar revised their methodology to calculate ratings in 2002, one major academic study has been published, by Pace University professors Aron Gottesman and Matthew Morey. Among the other studies that have been conducted are two that we have published at Advisor Perspectives.
The results of those studies, as well as data provided by Morningstar, suggest that ratings have limited value as predictors of future performance. This is not surprising. At its core, Morningstar's methodology is based on a fund's three-, five- and ten-year historical performance. Few subjects have been studied as carefully as whether historical fund performance can predict future performance and, on this count, the answer is clear. Virtually no scientific evidence exists that future performance, for periods longer than a year or two, can be predicted solely based on past results.
Morey and Gottesman evaluated the performance of actively managed U.S. equity funds rated by Morningstar for the three years beginning June 30, 2002. They found "widespread support for the notion that the new Morningstar rating system can predict future performance, at least within the first three years out-of-sample."
Their results were widely publicized and helped secure the value and status attributed to a five-star rating. They employed rigorous methodology, adjusting for risk and survivorship and concluded that the alpha (risk-adjusted return) for funds increased at each level of star rating, from one-star to five-star funds.
One problem remained, however.
The 2002-2005 time frame used by Morey and Gottesman was mostly a bull market. In a bull market, actively managed funds have less value and investors would be well served by index funds. A true evaluation of active managers and of the systems (like Morningstar's ratings) used to measure them requires a full market cycle, including bull and bear markets.
