# Morningstar ratings: Useful or useless?

The financial industry generally places more emphasis on style than substance. Because of this, when their work is actually evaluated, results tend to be disappointing. Wall Street’s earnings forecasts? Overly optimistic. Performance of mutual fund managers? Quite embarrassing. You may be wondering: Do Morningstar ratings also belong in the same category?

You’re probably familiar with Morningstar and their one- to five-star mutual fund ratings. Many investors rely on Morningstar for stock and mutual fund research, and mutual fund companies love using Morningstar ratings in their marketing materials. But is there any value in a five-star Morningstar rating? (Disclosure: I use Morningstar software sold to investment advisors almost everyday.)

The Morningstar ratings for one of the funds J.D. owns.

Fortunately for us, researchers recently looked into these ratings and published their results. They compared Morningstar ratings to fund expense ratios as a predictor of future performance.

The expense ratio is the annual fee for investing in a fund. This fee is charged by the mutual fund manager, and it’s one of my favorite metrics. If you assume that mutual fund managers have no value — which I find to be a very good approximation — you would expect lower costs to predict better performance. And the report found just that:

Expense ratios are strong predictors of performance. In every asset class over every time period, the cheapest quintile produced higher total returns than the most expensive quintile.

What about Morningstar ratings? Five-star ratings predicted better performance than one-star ratings in 13 of 20 observations — a success rate of just 65%. That sounds pretty good on its own, but it’s still worse than a metric that anyone can look up in seconds.

Since Morningstar uses prior performance (after fees) to calculate its ratings, the ratings already include information about expense ratios indirectly. So what is Morningstar adding with its fancy algorithm? Let’s use a little high-school algebra to find out. (Geek Alert!)

Morningstar Rating = Expense Ratio + Morningstar’s Additional Analytics

And we just found out that:

Expense Ratio > Morningstar Rating

Finally, using my graduate degree in math, I get this:

Yes, Morningstar’s algorithm is horrible. And that’s not all.

Morningstar reserves its five- and one-star ratings for the top and bottom 10% of funds. However, the researchers conducting this study divided expense ratios into quintiles — or, as normal people would say, 20% buckets. The expense ratios were handicapped by using 20% buckets instead of 10%, and still beat Morningstar ratings. Ouch!

Well, there’s one thing I forgot to tell you. People have performed this evaluation many times with similar results, so it isn’t news to serious students of investing. The interesting part of the report I quoted is the publisher: Morningstar. If you read its report [PDF], it sounds like a politician answering a tough question — uncomfortable. Independent thinkers can go directly to the results here [PDF].

Note: After writing this, I noticed that Morningstar clarified that ratings are indicators of past performance, and should not be used to predict future performance. If Morningstar were concerned about substance, it would tailor its ratings to how investors actually use them — as an indicator of a good investment. If it did that, most five-star rated funds would just be index funds. Unfortunately, Morningstar emphasizes style (and money), so it ends up with an imperfect rating system that benefits one of its biggest clients: mutual funds.

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### There are 22 comments to "Morningstar ratings: Useful or useless?".

1. Elysia says 20 October 2010 at 14:13

I read stuff like this and the article Sierra posted about 529s and I just get frustrated. I don’t know how to pick the right thing to do. I have a financial advisor through my credit union, she seems less than useful to me (doesn’t even offer options on 529s when the internal management fees for individual funds is 2.06% and the annual fee is 25\$). Research indicated to me that I wanted low mgmt & portfolio expenses (under 1.25% combined), no maintenance fees and no sales charges. Morningstar apparently lists this info on their site.
When I indicated that I was interested in index funds she just said that my portfolio is “growth oriented” but has no index funds.
My head hurts. What do I do?
I currently have MFS for everything but 401k, for 401k I have ING Retirement (which offers suggestions based on — Morningstar).

2. Nicole says 20 October 2010 at 14:37

I always wondered what those ratings measured (not enough to look them up though). They didn’t seem to match expenses so I couldn’t figure it out. I guess the market always does about a “3”?

Another thing you can do is go to the bogglehead forums and ask for help. They seem to know everything about everything there and are willing to walk you through things. (I didn’t ask, but I found threads where people had been in my situation.)

3. David says 20 October 2010 at 15:04

I suppose I’m not terribly surprised that a financial institution fails to see the forest for the trees.

4. Starshard0 says 20 October 2010 at 15:46

I’ve never really paid attention to the Morningstar ratings of my funds, I made it a point to look at the actual numbers and compare to other similar funds. I completely agree that index funds are going to be the winners every time since the fees are so much lower.

5. Roger Wohlner says 20 October 2010 at 21:24

Like Mr. Choi I am also na financial advisor who uses a version of Morningstar’s online software geared to financial advisors. I don’t frankly even look at the star rankings. Morningstar is a great provider of data for mutual funds, ETFs, Closed-end funds, stocks, etc. To me this is the value in their service and why I’ve used Morningstar since I started in the business in the mid 90s. I think the star system is used by many fund companies to promote their funds which is terribly misleading to the investing public.

6. Luke says 21 October 2010 at 01:22

Interesting article, very thought provoking.

As a new investor, it’s always useful to have a few pointers when it comes to fund performance. Still, I’ve always taken ‘star’ ratings/letter ratings etc. with a pinch of salt.

While past performance is no indication of future gains etc. etc. I tend to try and pick the funds that meet my investing style (large funds, growth, fairly agressive) and are also performing well vs. their sector/peers.

Still, it’s a minefield for regular investors who don’t have a financial background!

7. Andrew says 21 October 2010 at 05:39

I am a licensed broker and manage a few client accounts, although as I’ve stated many times on here before I believe everyone would be better served by increasing their own knowledge and managing their own portfolio. I am very much opposed to mutual funds in general, but that is nothing compared to my distrust for Morningstar’s rating system. It is simply a crutch to novice investors and a tool to transfer the blame if a fund does not perform well. It allows a losing investor to think “it was a 5 star fund when I bought it; it’s not my fault it didn’t do well.” However, it is this kind of logic that prevents one from becoming a better investor. Take responsibility for your investments and learn as much as you can. You can’t afford not to since no one will ever care for your money like you will.

8. Kevin M says 21 October 2010 at 06:45

Very interesting article, Edwin. It’s a shame there are so few comments.

I can’t say I’ve ever cared what Morningstar or any other ratings company said about any funds I’ve owned. I use the expense ratio as a first criteria whether to consider a fund or not. Looks like I’m on the right track.

9. Andrew says 21 October 2010 at 09:43

Morningstar gives Vanguard Institutional Index only 3 stars?

It’s expense ratio is just 0.05%

Anyway I shifted most of my 401(k) funds into it 🙂

10. Mike says 21 October 2010 at 12:03

I’m an advisor and manage accounts. I do not use actively managed mutual funds in my practice. In my opinion they’re too expensive and usually underperform the index that they are trying to beat. A very broad based low cost index strategy that invests in US, Developed and emerging market Mutual Funds for growth and short term maturity AAA and AA rated bond funds for safety might be the way to go. Size also matters, usually funds that invest in smaller value oriented stocks do better than large growth stocks over time. But they can also me more risky.

11. Janette says 21 October 2010 at 13:14

Investing takes work. Sorry, I have found few financial advisors in cheap suits. They are out there to make money- Off YOUR money. You can follow them- giving them a cut as you go along- or do it yourself.
Doing it yourself saves money and complaining (since you can only blame yourself). I work at it every day. Reading, listening, working the numbers and growing it. Got out of mutual funds a long time ago. Why should I pay an advisor to put me in a company to take another take?
I guess if I didn’t have the time I would go with a ETF…but that’s not going to happen again until I am in my 90’s :>)

12. Edwin Choi says 21 October 2010 at 14:50

Thanks everyone for the great comments.

@Luke (#6)

“I tend to try and pick the funds that meet my investing style (large funds, growth, fairly agressive) and are also performing well vs. their sector/peers.”

Although investing style/asset class is important to use, relative performance is essentially what Morningstar uses in its ratings. You should be careful about using recent performance in your evaluation.

13. Pirate Jo says 22 October 2010 at 15:55

It does seem that if a stock or fund has been skyrocketing (thus earning it a five-star Morningstar rating), it might be a good time to sell!

14. Rob says 23 October 2010 at 03:54

The author has applied a comparison of the averages of two sample sets (performance of the cheapest and most-expensive quintiles), to the particular results of Morningstar ratings (65% results outperform).

Instead, analysis should be applied to either of two questions:

1. How many funds (%) in the cheapest quintile outperform funds in the most-expensive quintile?
2. Does the average performance of five-star rated funds out-perform, ON AVERAGE, the average performance of one-star rated funds?

15. Luke says 25 October 2010 at 02:16

Thanks for the comment Edwin.

I also consider things such as the TER, the age of the fund and how it has performed historically.

Again, I don’t assume future performance to be the same as past, but isn’t it logical to have more faith in a fund that has produced decent returns for 20 years than a brand new one that hasn’t yet proven the management skills of the fund managers?

16. Edwin Choi says 26 October 2010 at 16:55

Hi Rob (#14), thanks for commenting. Here are my thoughts on the concerns you bring up.

1. Unfortunately the research report did not look at % of cheap funds that outperform expensive funds (or % of 5-star funds that outperform 1-star funds). However, they did look at % of funds that survived and outperformed all their peers, calling it the success ratio. Not exactly the question you had in mind, but fairly close.

Expense ratios did better than ratings in predicting both the success ratio of the top bucket of funds (lowest expense and 5-star rating respectively) and the difference in the success ratio between the top and bottom buckets (lowest vs highest expense and 5- vs 1-star ratings).

The linked research report goes into far more detail regarding the different criteria they used to compare the predictive power of expense ratios and star ratings.

2. Fortunately, the research did look at average performance of the top vs bottom buckets. In 65% of the categories, a 5-star rating predicted higher average returns than 1-star ratings. Pretty good, except that lowest-expense ratios predicted higher average returns than highest-expense ratios in 100% of the categories.

Luke (#15),

I definitely agree that expense ratios are not the one and only criteria you should look at. There are many other factors you could consider, future viability of the fund company being one example. However, I believe most investors put far too much weight on historical performance. Remember that Morningstar ratings consider returns going back 10 years, and they still fail to match the predictive power of expense ratios.

17. Kevin Cimring says 03 February 2011 at 17:35

Hi J.D. – this comment comes a long time after the original article was written but the issue of Morningstar and other ratings is a very interesting topic. My colleagues recently completed some research on the Morningstar Fund Managers of 2010, and I thought readers might find the resultant article very interesting: http://www.jemstep.com/blog/2011/01/are-the-morningstar-fund-managers-of-the-year-2010-the-best-for-you/
Kind regards,
Kevin

18. Phil says 08 December 2012 at 11:25

Morningstar is a great data resource. The star ratings can be helpful but is limited. The info on expenses, portfolio content, and past performance is more useful than the stars. Having said that, a portfolio of all five star funds has done me well over the years and keeping to such fund companies as Vanguard, T Rowe Price, Fidelity, and some of the better smaller no load shops gives the investor a price advantage as well as a performance advantage.

19. Xoche says 06 October 2014 at 10:53

Morningstar is a dishonest service that practices sales tactics that I wouldn’t expect to see in the financial world. They will bait you with a \$23.99 cost of a monthly membership, and bury the part about it being “recurring” in the terms and services, refusing to refund the amount they misled you into paying.

I’ve worked with much lesser known companies who, after complaining about this type of bait and switch tactic, will refund your money. Not morningstar. It seems like they need to depend on misleading their customers to make any money.

• Lee Rhodes says 12 February 2016 at 08:49

It is fully disclosed.

20. Gguppy Gghyu says 31 October 2014 at 16:22

Ive noticed similar phenomenon with ratings system.

1. Analysis issues buy signal…after price goes up.

2. Sell signal ….after price goes down

Historical accuracy….releativly poor.

Ratings systems seem to hold no value with regard to the future. They seem to only give good scores to companies that…did good. Past tense

Basically they have you buy high and sell low unless you get lucky.

Also, bogle head research shows the previous top performers often do poorly lateron. Do you blame them, after a few years of outperforming markets a sector or business gets tired or has bad luck. Nothing goes straight up forever.

So the best rated then may often be the highest price and closesest to correction.

Buy good companies at a sensible price and ignore the bull and bear markets, thats the best advice I have ever heard. Sensible price for a good companies seems to be after a good correction or bear market.

Have fun dont let the market give you a heart attack.

21. Bob DesRochers says 22 October 2015 at 08:16

I’m not sure that financial advisors offering a critique of another financial advisor is very helpful. I don’t subscribe to Morningstar and never have BUT this article seems self-serving.