Reading the Stars: Age Bias in Morningstar Ratings

Abstract

Comparisons of Morningstar ratings may be affected by fund age and market conditions during the evaluation period.

The 2002 revisions to the Morningstar rating system for mutual funds benefit all investors by providing a convenient signal of fund quality that is better grounded in investment theory than the old system was. The most significant improvement is the refinement of the benchmark groups against which the performance of individual funds is measured. An age bias still exists with the new ratings, however, and should be considered in the fund selection process.

One source of the age bias is the differential weights that a fund's most recent 36-month returns receive in the calculation of its overall star rating. The younger the fund, the more its overall rating depends on these returns. In our examination of this source of age bias, we are able to reconcile some differences in previous findings.

A second source of age bias is the market climate during the evaluation period. The time period over which relative performance is evaluated matters. A bull market can make even weak funds look enticing, and a bear market can make even the best funds look uninviting. Comparing funds is difficult when one fund's overall star rating reflects mostly bear market returns (the case with today's young funds) and another fund's overall rating contains both bull market and bear market returns (the case with today's older funds). To identify superior management, investors should compare fund performances in uniform market conditions.

The third source of the age bias is an interaction between fund age and fund size. Young funds tend to be small, which makes their returns and ratings susceptible to manipulation. For example, the smaller the portfolio, the more a handful of fortunate stock picks can buoy the performance of the entire fund. The strategy of stuffing a young fund with a few hot stocks is likely to result in a higher star rating, but it may not result in sustainable long-run performance. Furthermore, because a young fund is typically small, mutual fund families may be able to waive some of its expenses. This strategy is likely to result in a higher star rating for the fund. Mutual fund management companies, which want to increase flows to the fund family as a whole, can exploit this aspect of the rating system by continuously introducing new funds. This practice tends to guarantee that the company always has at least some highly rated funds in its family, thus ensuring increased flows of new investment dollars.

In summary, comparisons of funds on the basis of their overall star ratings must be made with three important considerations in mind. First, a fund's overall star rating is heavily influenced by its most recent 36-month returns, but the weight of these returns depends on the fund's age group. The older the fund, the lower the weight. Second, comparing star ratings earned over the same time period is more meaningful than comparing performance for different periods. Finally, young funds tend to be small, which makes their returns susceptible to manipulation. Investors should be cautious (1) when comparing funds that are in the same age group but for which the returns came from different time periods and (2) when comparing overall star ratings of funds in different age groups.