The Most Powerful Force in the Investment Universe

Einstein was wrong.

Not about his theory of relativity, which was proven accurate again this week by the release of the first-ever photograph of a black hole.

Einstein was wrong when he was famously quoted as saying the most powerful force in the universe was the power of compound interest.

Had he lived long enough, Einstein may have concluded that the most powerful force in the investment universe is the ubiquitous star rating system developed by global research titan Morningstar some 30 years after Einstein’s death.

Developed in 1986, Morningstar’s fund rating system of 1 to 5 stars has long been the most influential determinant factor a majority of investors use to select mutual funds, more so than brand identity or fees.

Over the years, I’ve been questioned hundreds of times by investment professionals and mutual fund marketing managers frustrated by what they incorrectly perceive to be a subjective Morningstar star rating that favors one fund over another. However, star ratings are purely quantitative in nature.

Morningstar, arguably the most recognizable brand in the mutual fund industry, does use subjectivity to rate funds in certain way. But more on that later.

In simple terms, Morningstar’s star rating is a measure of a fund's risk-adjusted return, relative to similar funds. Funds are rated from 1 to 5 stars, with the best performers receiving 5 stars and the worst performers receiving a single star.

The star rating is a purely mathematical measure that shows how well a fund's past returns have compensated shareholders for the amount of risk it has taken on. Morningstar fund analysts don't assign star ratings and have no subjective input into the ratings. Morningstar doesn't subtract stars from funds they don't like or add stars to those they do.

Morningstar star ratings are based on the fund's past performance as compared to other funds in its specific Morningstar category. It serves as an easily understood point of reference for financial advisors to use with clients and is frequently used by do-it-yourself investors as a starting point for additional research.

In the rating process, 10% of a category's funds with the lowest measured risk are assigned 5 stars. The next 22.5% are rated below average risk and rated 4 stars. The middle 35% rates 3 stars, the next 22.5% are assigned 2 stars, and the 10% of funds in the category with highest risk are rated 1 star.

Morningstar rates funds for as many as three time periods – the trailing three, five, and 10 years – and ratings are recalculated monthly. Updated star ratings are posted to Morningstar’s site approximately three business days after month end, creating a sizeable uptick in web traffic from advisors and investors .

Funds with less than three years of performance history are not rated. For funds with only three years of performance history, their three-year star ratings will be the same as their overall star ratings. For funds with five-year records, their five-year histories will count for 60% of their overall rating and their three-year rating will count for 40% of the overall rating. For funds with more than a decade of performance, the overall rating will be weighted as 50% for the 10-year rating, 30% for the five-year rating, and 20% for the three-year rating.

A common criticism of the star system is that it is entirely based on how a fund has performed against its peers. And, as investment managers know, past performance cannot guarantee comparable future results.

Nevertheless, style is often valued over substance. Statistics time and again show that 4- and 5-star funds garner almost 100% of the new money invested in mutual funds, while funds with 3 or fewer stars are almost universally found to be in net redemptions. There’s no more precarious point in the mutual fund industry than to be a 3-star fund nearing a 4-star rating or a 4-star fund on the verge of falling to 3 stars.

Having worked with mutual fund portfolio managers, chief investment officers, and Morningstar analysts and served as an industry consultant for more than 20 years, I’ve found that improving a fund’s risk-adjusted return isn’t the only way to positively influence star ratings.

To its credit, Morningstar conducts a review process twice a year to make certain a fund is placed in its proper investment category based on objective statistics taken from each fund’s publicly available list of portfolio holdings . Among the subjective factors Morningstar analysts consider as part of its categorization process are its level of familiarity of the investment processes used by portfolio managers and the fund company overall.

What most fund companies don’t realize is that Morningstar’s fund categorization process is a two-way street. Morningstar will inform fund representatives of a pending category change before it takes effect.

Conversely, Morningstar takes into consideration research submitted by fund companies which believe one or more of their funds have been placed in the wrong category or need to be placed in a different category based on a change in investment process, investment objective, or incorrect or incomplete data. The appeals process can change a fund’s star rating as long as the supporting information is factual and not philosophical.

As influential as they are, star ratings are not the only way Morningstar can make or break a fund’s asset growth. With star ratings tantamount to looking in a rear-view mirror, Morningstar’s Analyst Rating for funds provides advisors and investors a way to see a fund through the windshield based on subjective, forward-looking analysis.

Morningstar Analyst Ratings are assigned on a five-tier scale – gold, silver, bronze, neutral, and negative. The difference in the top three ratings corresponds to differences in the level of conviction Morningstar analysts have in a fund’s ability to outperform its benchmark and peers through time, within the context of the level of risk taken.

In its forward-looking subjective analysis, Morningstar’s analyst team focuses five key areas they believe to be crucial to predicting the future success of funds: people, parent, process, performance, and price.

Advisors and investors increasingly rely on Morningstar Analyst Ratings in addition to star ratings when deciding which funds are most suitable for their investment needs.

The process of determining Morningstar Analyst Ratings is often misunderstood by fund companies which may not fully comprehend and appreciate the ways in which a well-developed plan by an experienced consultant can positively influence a subjective analysis.

Fund marketing materials often underscore the valuable advice given by Nobel Prize-winning economist Robert Shiller that people make better decisions with financial advisors.

Fund companies can benefit in much the same way by foregoing a pure do-it-yourself approach and enlisting professionals who have more than 20 years of experience working with Morningstar.

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