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Oh, Those Stars in Your Eyes

You might say Morningstar's unofficial philosophy is: "Listen to me, just not so closely."

One of the biggest supporters of the notion that Morningstar ratings should not have too significant an impact on mutual fund flows is Morningstar itself. While the company believes the star-ratings are a helpful tool for investors, it is wary of having investors rely on them when developing a portfolio.

For mutual fund companies, however, the equation is simple: you get five stars, you get more money.

In a recent study, researchers from the University of Oregon and the Federal Reserve Bank of Atlanta concluded that the stars Morningstar awards to funds have a big effect on flows. The researchers found that for previously unrated funds, a retrieval of a five-star rating brings in $26 million, 53% above the expected normal flow. Being upgraded from four to five stars brings in an additional $44 million, 35% above the normal flow.

The idea that consumers flock to ratings is not surprising. The success of restaurants and hotels can hinge on what kind of star rating they get from The New York Times or a Michelin guide. The same is true of a mutual fund when it comes to Morningstar ratings. The difference, however, is that the Morningstar rating is not subjective. It is based on calculations incorporating historical cost, risk and return. So investors have a reason to follow Morningstar's ratings, right?

Following Reason

Yes and no, according to Don Phillips, Morningstar's managing director and former CEO. "We've never pretended that investors should look at the star ratings and stop there," he said. "We've never run an ad saying, Follow the stars to the riches,' because that's just not realistic. Over the last 10 years we've been trying to push investors beyond the notion of good versus bad funds. It's about what is appropriate versus what's inappropriate."

Earlier this year, an investor wrote in to to ask what he should do with his American Century Ultra fund now that it had moved from a four-star to a three-star rating. Morningstar's response? Easy, tiger. "Far be it from me to dismiss the measure that helped make Morningstar's name, but the star rating shouldn't be your guide for selling or buying a fund," wrote Peter Di Teresa, a senior analyst with the company.

Still, whether or not investors should be using the star ratings as a guide to buy and sell funds, evidently they are. And it is not only the five-star ratings that matter. Although initial ratings of three or four stars have little or no affect on flows, the movement down to three or up to four has a significant, if lesser, impact, according to the study. With that in mind, mutual fund companies have to worry about ratings during the entire life of the fund. If a downgrade in performance doesn't drive investors out of a once high-flying fund, a downgrade in star rating might.

"[The] inconsistency between the response to changes and initiations leads us to conclude that the presence of a previous rating materially affects aggregate investor reallocation decisions," according to the study.

Clearly, many fund companies already believed that Morningstar's ratings matter to investors. Advertisements are littered with references to funds' historical and current star-ratings. Phillips, however, does not believe the stars have as much of an effect on flows as the study suggests. "It's funny. A lot of people often say we're the 800 pound gorilla that can drive fund flows, while we're saying that it's more of a correlation than a causation," he said.

800-Pound Correlation

The correlation is indicative that the stars accurately reflect the criteria investors look for in a fund, he said. If anything can be taken from that, it is that investors are more concerned with long-term performance than in chasing the last quarter's performance and that they care about risk versus cost, he said. "Whether they determine that by blindly following the stars or by figuring in a number of different factors is impossible to tell," he said.

The study, titled Star Power: The Effect of Morningstar Ratings on Mutual Fund Flows is based on monthly data on 3,388 domestic equity funds from November 1996 to October 1999, and incorporates over 12,000 rating change events into the results. The fact that Morningstar uses a one- to five-star ranking system and that the information is at such a low cost to investors made Morningstar well suited for the research, according to the study.

Morningstar is not the only company that rates mutual funds. Standard & Poor's chooses funds as "Select" funds and Lipper announced late last month that it will compete with Morningstar and offer mutual fund ratings to retail investors and advisors (MFMN 8/28/01). "[Morningstar] is a brilliant marketing company and they've gotten some very good press on the ratings from the beginning," said Andrew Clark, a research analyst with Lipper.

The company is introducing the ratings as a tool to use in the mutual fund selection process, not as a guide to buy and sell funds, but the new ratings could have a similar affect on investors that the Morningstar stars do, said Clark. Like Morningstar, Lipper intends to be clear that the ratings have limitations, he said. "Morningstar has always stressed that the stars are not predictions on funds and there is much more to look at , but investors seem to ignore that caveat a lot of the time."