Morningstar’s (MORN: $82/share) ETF and mutual fund ratings have been the go-to standard in the fund industry for decades now, and the company does an impressive job of providing research on a massive number of funds.
Millions of investors rely on Morningstar’s research. Some would say there is so much reliance that changes in Morningstar ratings have a significant impact on mutual fund money flows. Many have observed accelerated growth in assets under management (AUM) for funds that get upgraded to a four or five star rating from MORN. Few would attempt to argue that Morningstar’s influence is formidable. The company sets the standard for marketing research services.
And it appears this marketing really pays off as a Vanguard study in 2010 showed little evidence of outperformance for five and four star-rated funds. In other words, Morningstar’s ratings drive investors’ investment decisions even though the ratings do not appear to be very indicative of future performance.
Perhaps, this disconnect is due to the fact that MORN’s fund ratings are almost entirely based on the past performance of ETFs and mutual funds. The investment quality of the holdings of funds hardly comes into play. I find this ironic because the performance of a fund is only as good as the performance of its holdings, and a rating that doesn’t take into account the holdings is not really predictive.
In addition to looking at a fund’s track record, one needs to look at its current holdings to gain insight into future performance. That’s why our predictive fund ratings are based on our stock ratings of the fund’s holdings as well as the fund’s total annual costs.
Figure 1 shows several examples from recent years where New Constructs and Morningstar have had contradictory ratings on funds. In most of these cases, Morningstar has had a positive rating and New Constructs has had a negative rating, as Morningstar’s ratings are overwhelmingly biased towards positive ratings. However, there are also cases where Morningstar’s ratings were more negative than ours.
