Morningstar Governance Ratings Cause Rift, but Debate Misses the Real Issue
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Thursday, September 23, 2004

Morningstar Governance Ratings Cause Rift, but Debate Misses the Real Issue

Are fund firms truly unhappy that Morningstar has rolled out its corporate governance ratings for funds, or are financial reports finding division where there is none to make a good story? In the end it really does not matter: Morningstar will keep its ratings (we will bet on it) while fund firms are looking like whiners. Just take a quick look at the Financial Times.

In "Controversy on Morningstar rate plan" the New York-based reporter Deborah Brewster writes that Morningstar is causing controversy in the fund industry with its new ratings. The fund tracker started with A-F governance ratings on 700 funds and plans to add another 1,300 over the next nine months.

Interestingly, Brewster does not use any named sources from the fund industry in the article. Instead, she explains that "Few fund companies were willing to voice their complaints publicly, but most said it was not possible to measure corporate governance with a rating."

The only named source is fund industry consultant Geoff Bobroff, a fund consultant, said: "Morningstar should stick to their knitting, which is measuring investment returns. He is also quoted as saying that "They [Morningstar] do not have the expertise to judge companies' corporate governance."

Remember, Joe Mansueto and Don Phillips had no recognized expertise to judge fund investment performance when they started the company in a Chicago apartment either. That did not stop them from gaining influence and success. It may be the same when it comes to corporate governance.

The more interesting question about the ratings is not whether they should be attempted at all (Morningstar has done it, so they are a moot issue), but how well they predict the future.

One way to do this would be to track "governance defaults", or those cases in which firms suffer a governance failure. Once those events have been tracked it would be possible to compare the rate of those events to the original Morningstar ratings. At that point, we would have statistics equivalent to bond default experience in the bond ratings industry. It is that experience that gives bond credit ratings their meaning, not the symbols used to differentiate the categories.

Until we have that experience and those statistics from Morningstar we really will not know what an A or an F means.

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