You may have caught wind of the recent feud between the Wall Street Journal and Morningstar over an exposé piece in the Journal questioning the usefulness of Morningstar's star rating system.
Not to be outdone, Morningstar slammed the Journal's research methodology in its own article, along with letters from two top executives, and claimed the WSJ writers fundamentally misunderstood the star system's intended use. The two industry heavyweights traded several more rhetorical blows over the following days. But aside from its entertainment value for those of us in the industry, this saga contains some timeless lessons for advisors and investors.
Don't Be an Unintentional Momentum Investor
Advisors who screen only for funds with 5 stars have typically already missed most of the strong relative returns that put the fund ahead of its category peers in the first place. It's a form of momentum investing — buy what's done well recently in the hopes that it keeps doing well.
We've also seen more than a few advisors fall victim to the mistake of selling a fund just because it drops to 3 stars (or 4). They know Morningstar is one of the first places their clients will go to research the funds in their portfolio, and it's easier to convince clients of the merits of buying highly rated funds and selling low-rated funds than it is to defend a fund that has performed well in the long run but whose style is temporarily out of favor.
Screening for highly rated funds is not an inherently bad practice, and Morningstar itself says the star rating system is designed simply to "tilt the odds" in investors' favor and serve as a starting point for research, not be an end-all metric. But is the tilt really all that meaningful?
You're Not the Casino
In defense of the firm's "tilting the odds" position on its star ratings, Morningstar managing director Don Phillips made the point that "dismissal of small advantages is precisely the human dynamic that casinos and many financial services companies use to exploit their customers." It's true that in aggregate, 5-star funds tend to slightly outperform those with 4 stars, which slightly outperform those with 3 stars, and so on.
