Morningstar: Friend or Foe?


Morningstar is a data aggregation warehouse that organizes the data of tens of thousands of mutual funds into uniform measurement templates that help consumers draw conclusions about which mutual funds may be the best to own.

Morningstar has received quite a bit of attention lately. The Wall Street Journal released an article pointing out the inherent flaws in Morningstar’s methodology, and the negative ramifications their well-known star rating system has on decision makers.

Some came to Morningstar’s defense, arguing the value of the insight provided by a uniform methodology to measure success in an otherwise non-transparent and poorly understood investment vehicle. The data uniformity makes comparisons possible and helps consumers make better educated decisions.

From my experience, the Wall Street Journal’s perspective seems more accurate than not. In meeting with advisors as an investment consultant, it is clear that many advisors misunderstand the information Morningstar makes available to them and may draw conclusions from that information that are incorrect, and can lead to less-than-optimal decisions when it comes to fund selection.

False Conclusions

It all seems so simple, a five-star rating equals a good fund and a one star rating equals a bad fund.  Yet, that simplicity can actually lead to suboptimal decisions by investors trying to select appropriate funds for their asset allocation strategies.

  1. Inaccurate classifications caused by unique mandates
    • Sometimes Morningstar just doesn’t have an appropriate category for certain types of funds. Or the methodology they use to classify a fund causes it to be inadvertently placed into a category that doesn’t fit the fund well.
    • An example of this flaw is in the managed volatility mandate. Managed volatility invests in low-beta stocks across a respective market with the purpose of gaining exposure to the market without subjecting the strategy to the volatility inherent to the asset class.
    • This mandate can move across the entire market to find low-beta securities, which may result in the mandate being more concentrated in a particular section of the market, leading to a different classification than its benchmark.
  2. Meaningful differences in fund mandates within a classification
    • Let’s take a look at the large cap category, the largest, most simple and efficient category in making this point. Most would expect the products to be fairly homogeneous, but nothing could be further from the truth. Large cap mandates can be wildly different from one another. Those differences can lead to meaningful differences in return, which can lead to abundant differences in peer rankings over time.
    • Consider the two most common focuses of large cap managers:
      • Value – buying securities that appear to be undervalued relative to their earning potential.
      • Momentum – buying securities that are trending strongly upward in a growth segment of the market looking for continued future growth.
    • There are clear periods of time in history where value investing has been in favor over momentum investing and clear times in history where momentum investing has been favored over value investing. This is another situation where the philosophical approach to investing in large cap securities can drive their performance results. The rating system Morningstar applies does not provide insight into these nuances and may lead consumers to choose a mandate that may have returns fueled by a market environment that is coming to an end, which could lead to a changing of the sources of return in the market and disappointment with that decision in the future.
  3. Structural differences in the funds within a classification
    • Sometimes funds have philosophical deviations in how a mandate is applied.  Simple things, such as how they handle currency hedging, can create broad separation in performance over time, resulting in broad deviations in the fund’s peer group rankings.
    • In the emerging markets equity category, there are three primary ways a mandate can choose to manage its currency exposure:
      • Fully hedge currencies back to the dollar
      • Don’t’ hedge the currencies back to the dollar
      • Partially hedge the currencies back to the dollar
    • As you can imagine, the chosen methodology can have a big impact on success relative to peers.  As a result, in a strong dollar market, funds that hedge back to the dollar should look attractive relative to those that are not hedged back to the dollar. However, in a weak dollar market, funds not hedged back to the dollar should look more attractive. Finally, currencies can be highly volatile, so making an investment decision to remain partially dollar hedged and partially local currency exposed provides a middle ground approach that should provide more stable middle of the road results, but if the decision is based on the star rating, these funds are less likely to be chosen over time, because they are less likely to hold a five-star rating at any time period.
    • The point is that there is no metric within Morningstar to allow consumers to understand this critical variable and make educated decisions. Consumers blindly selecting funds with a five-star rating could be getting a fund that was driven by the strength of the dollar as opposed to the strength of the security selection within the fund.
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Morningstar is a useful tool for naïve comparison of funds across a category, but that is where the deeper analysis should begin. A deep dive into the mandate and objective of the funds in question to identify the true drivers of return in an effort to:

  • Ensure that the fund being analyzed is in an appropriate categorization
  • Understand how the most recent and current market environment impacted the performance of the product
  • Review any structural decisions made by the management team and how they may have impacted the funds’ return, risk and peer group orientation

The biggest takeaway is that the star rating system can be biased by the funds’ predisposed orientation relative to the most recent market environment and should be taken with a grain of salt when determining which fund may fit best in an investor’s strategy. Forgoing the deeper analysis has a high likelihood to set the strategy up to fail as market drivers change and the fund’s mandate may fall out of favor.  Remember, a one star fund could very well be a better option than a five-star fund given the nuances discussed here, but most would never consider that a reality. Next time you’re reviewing a Morningstar analysis, please stop to think about these nuances and the impact to your choices.

Beta: Quantitative measure of the security’s volatility relative to the benchmark used. A beta above 1 indicates the security is more volatile than the overall market, while a beta below 1 indicates the security is less volatile.

Information provided by SEI Investments Management Corporation. The content is for educational purposes only and is not meant to provide investment advice or as a guarantee of any specific outcome.

Investing involves risk, including possible loss of principal.

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John Frownfelter

John Frownfelter

John Frownfelter is the investments contributor for Practically Speaking and the managing director of investment solutions within the SEI Advisor Network.

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