Ratings are more about rewarding (and thus incentivizing) good behavior and the right focus than they are about predicting the future. So argues veteran Morningstar insider Don Phillips in his latest defense and contemplation of the Chicago-based investment research giant's most ubiquitous product, its 33-year-old star ratings system for mutual funds.

Phillips likens M*'s fund ratings to schools' grades for students:

"Schools don't assign grades to help future employers identify the best hires; schools assign grades to motivate better student behavior," Phillips writes. "So, too, do the stars discipline managers to behave in a more shareholder-friendly manner," i.e. focusing on "greater prudence and predictability."

For fundsters interested in history, Phillips offers some context about the investing world of the mid-1980s, when M* founder Joe Mansueto launched the star ratings system. And Phillips continues to make the case for the star ratings being a mild predictor of future success, while helping investors steer clear of some funds (low-star ones) that are more likely to suffer (due to fees, or unrewarded risk-taking, etc.).

"The stars are a starting point, not a conclusion — a grade, not a prediction ... The stars are mildly predictive," Phillips writes. "Because long-term returns and ongoing expenses have a negative correlation, the stars still effectively tilt investors away from high-expense funds, and they modestly up the odds of good investor outcomes. Not bad for a first-stage screen."

Avoiding likely losers, Phillips argues, is a key benefit of the star ratings.

"Few if any people build consistently winning portfolios out of 1- and 2-star funds," Phillips notes.

Though there are many other fund evaluation options, even from M* itself, the star ratings still have significant power in the fund investing world. Over the weekend the FT highlighted analysis from Flowspring suggesting that M*'s star ratings are the third biggest driver of fund flows (behind track record length and fees).

For fundsters looking for more context on the debate over star ratings, here are updates from 2017, 2013, 2012, 2010 (twice), and 2007. 

Edited by: Neil Anderson, Managing Editor


Stay ahead of the news ... Sign up for our email alerts now
CLICK HERE