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Morningstar Stars Said to be Losing Impact

Morningstar stars may be losing their sparkle, according to two recent reports.

Performance data appears on websites all over the Internet, taking some of the prestige and importance out of the stars that fund tracker Morningstar of Chicago awards top-performing funds, according to Merrill Lynch of New York and Barra Strategic Consulting of Berkeley, Calif. The two firms issued a report in June called "Success in Investment Management: Building and Managing the Complete Firm."

Less than 50 percent of funds which are awarded Morningstar's highest rating of four or five stars, remain highly ranked over three years, according to an article in the September issue of the Journal of Financial Planning. The article, "The Persistence of Morningstar Ratings," was written by three researchers, including a former senior economist of the Federal Reserve.

The researchers examined how well four- and five-star mutual funds performed for three years after receiving the honor. In general, they found that "persistence is hardly assured and is somewhat variable across years and investment categories." For example, in 1998, of the 1,897 mutual funds that had four or five Morningstar stars, only half retained those stars throughout the year, according to the study.

Merrill Lynch and Barra, meanwhile, said that up-to-date performance reported on various investor websites could supplant the significance of Morningstar rankings.

The Merrill Lynch / Barra study makes several other predictions as to how the fund industry will change besides by the decreased importance of Morningstar fund rankings. Alliances, partnerships and acquisitions will continue at a rapid pace, according to the study.

"Competing firms will find it necessary to enter into relationships with one another in order to source investment manufacturing, leverage distribution channels, and outsource operations," the study said. "Successful firms will focus exclusively on the activities that they do best, using client/partner/competitor relationships to deliver the balance."

Four leading business models will emerge in the investment management industry, the study said. Leading firms will either be distribution specialists, specialized niche investment specialists, financial holding conglomerates or they will offer various investments through a single distribution channel, the study said.

Mutual fund complexes and other types of investment firms will also have to become more customer-driven with high-quality investment products and tailored service, the study said. The "proliferation of mediocre products" that exists today will not persist, because investors will not tolerate it, according to Merrill Lynch and Barra.