For better or worse, Morningstar’s well-known “star ratings” often hold great influence over the behavior of individual investors. Unfortunately, this reliance is rarely accompanied by a clear understanding of the rating methodology and, more importantly, its implications.
Morningstar ranks funds within their respective categories according to each fund’s risk-adjusted return (Morningstar adjusts for risk by subtracting a “risk penalty” from each fund’s total return based on the variation in its month-to-month return). Star ratings are assigned such that the distribution reflects a classic bell-shaped curve: the 10% of funds in each category with the highest risk-adjusted return receive five stars, the next 22.5% receive four stars, the middle 35% receive three stars, the next 22.5% receive two stars, and the bottom 10% receive one star.
Funds are rated for up to three periods – the trailing three, five and 10 years. For funds with only three years of performance history, their overall star rating will simply equal the three-year rating. For funds with five-year records, the overall rating is a weighted average of the five-year rating (60%) and the three-year rating (40%). Similarly, for funds with more than a decade of performance, the overall rating is a weighted average of the 10-year rating (50%), the five-year rating (30%) and the three-year rating (20%).
Though this may be obvious, it is critical to note that the Morningstar rating is simply a reflection of past performance. And academic research has repeatedly demonstrated that mutual fund managers are generally unable to consistently and predictively deliver superior performance – consequently, today’s five-star funds are unlikely to be the five-star funds of the future. Rather, it is persistent differences in mutual fund expenses, not historical performance, that explain almost all of the predictability in mutual fund returns (i.e., low-cost funds typically outperform higher-cost funds).
The nature of the star rating system leads low-cost, passively managed funds to typically be assigned a three- or four-star rating. A five-star or one-star rating is very rare for a passively managed fund given that such ratings are indicative of extreme performance – which is counter to the mission of a passive fund that is structured to replicate, not deviate from, market performance.
The rating of a passively managed fund is largely driven by the general performance results of the asset class or investment category the fund is designed to mimic. For example, foreign emerging markets have been one of the best-performing investment categories over the past five years (+10.81% annualized as of 5/6/09). Because a passively managed fund is both fully invested (minimal cash allocation) and pure to its investment category (holding only emerging market stocks), passive funds have done well relative to actively managed peers which may have held higher levels of cash and/or maintained holdings that fell outside of the emerging market universe (e.g., similar, but lower-performing, foreign developed market stocks). Consequently, passive funds such as DFA Emerging Markets, DFA Emerging Markets Small Cap, DFA Emerging Markets Value and DFA Emerging Markets Core Equity are each currently assigned a four-star rating.
Conversely, U.S. large-cap value is one of the poorer-performing investment categories over the past five years (-1.69% annualized as of 5/6/09). Consequently, DFA U.S. Large Value is currently assigned a two-star rating as minimal cash (which is a drawback during periods of negative returns) and holding stocks exclusively from the U.S. large-cap value category (rather than similar, but better-performing, small- or mid-cap value stocks) has been a performance disadvantage for the passive fund relative to its actively managed peers.
Also, a limited fund history and/or the Morningstar category to which a fund is assigned can distort the star rating system. For example, DFA International Core Equity has been placed in Morningstar’s Foreign Large Value category and is currently assigned two stars. Because this passive fund has less than a five-year record, the rating is based only on the last three years. Additionally, rather than being exclusive to foreign large-cap value stocks, this fund is an efficient integration of four underlying DFA funds across different investment categories: DFA Large Cap International, DFA International Value, DFA International Small Company, and DFA International Small Cap Value – each of which has a ten-year plus record and an overall Morningstar rating of three or four stars.
While Morningstar provides an excellent resource of information for investors, their star ratings can be misleading and/or misinterpreted. Over longer periods of time, the inherent cost advantage of passive strategies, combined with declining performance differentials across similar investment categories, leads most passively managed funds to three- or four-star ratings.