Mutual fund star ratings: More fiction than fact

When it comes to making buying decisions, star-based ratings can be a good barometer of whether handing over one’s money will be worth it. We might patronize a five-star business based on Google Reviews or avoid a product on Amazon after seeing it’s received a slew of two-star ratings.

When it comes to investing in mutual funds, we’ve long known star ratings don’t tell the full story.

But what if you learned fund ratings had been manipulated higher to make poor performing funds look artificially better?

Fact or fiction?

Such is the conclusion from researchers at Harvard Business School and MIT’s Sloan School of Management who examined Morningstar’s mutual fund star rating system.

The paper, titled “Box Jumping: Portfolio Recompositions to Achieve Higher Morningstar Ratings,” finds that active mutual fund managers intentionally, strategically, and temporarily change their portfolio holdings so that their Morningstar classification changes to a different “style box” in which the benchmark has delivered lower average returns.

The intent is for the active mutual funds to look better—relative to their new style box, category, or benchmarks—ultimately improving their Morningstar rating.

Why do high Morningstar ratings matter? Separate research studies have found investors reward highly-rated funds with positive cash flows, increasing a fund’s assets under management and, thus, profits.

Fund managers have purposely – and frequently – used box jumping strategies since Morningstar revamped its rating system in 2002, according to the paper. And it’s worked: Funds receiving a higher rating realized a 6.7% jump in assets under management in the 12 months following the upgrade. In many cases, fund managers also used the ratings bump to justify an increase in management fees.

More to the story

While it’s bad enough investors are being duped into investing in poor-performing funds which have simply changed their stripes, the paper’s authors reported that such funds went on to underperform those awarded legitimate five-star ratings by about 8% in the five years after receiving their new rating.

The rating upgrade was also temporary. “We also show that ratings upgrades driven by box jumping are transitory,” the authors wrote. “While funds receive an immediate ratings upgrade upon box jumping, the upgrade is completely reversed within three years.”

Telling a different story

If star ratings don’t tell the full story, what should mutual fund investors pay attention to instead?

Fees, as measured by a fund’s expense ratio.

Morningstar admitted as much nearly fifteen years ago, when it released a study concluding that low fees were a better predictor of future performance than was their own star rating system.

That study looked at mutual performance from 2005 to 2009 and found low-cost funds beat high-cost funds in all time periods for every asset class included in the study.

The fact that fees are a better indicator of a fund’s future performance is a primary reason we’ve used low-cost index and asset class funds since the day we opened Vista’s doors.

What matters most

For decades, however, too many investors have fallen prey to star ratings and other media hype touting yesterday’s best performing mutual funds.

The new “box jumping” research reveals how star ratings can be manipulated by active managers in pursuit of short-term profits.

It should also serve as a stark reminder to investors that a higher star rating is far from a guaranteed predictor of future success; in fact, it may just be the result of managers gaming the system.

We’ve long eschewed traditional active management (which is reliant on forecasting, stock-picking, and market timing) in favor of well-diversified portfolios anchored by low-cost funds focused on sources of higher expected returns. A focus on stars has never been part of our process.

By continuing to focus on what does matter—low costs chiefly among them—we aim to deliver successful outcomes for clients seeking to protect and grow their wealth.  

Recommended reading:

Lauren Cohen, David S. Kim, and Eric C. So. “Box Jumping: Portfolio Recompositions to Achieve Higher Morningstar Ratings.