Morningstar Magazine - April/May 2018 - 12

Dispatches

The Utility of Grades
The star rating creates
the incentives we
all want fund managers
to have.

PHILLIPS CURVE

Don Phillips

In the mid-1980s, as the number of U.S.
mutual funds swelled past 1,000, it became clear
that an individual investor or financial
advisor could no longer perform due diligence
on all the available choices. Some sort
of screen or means of grading the prospects had
become essential. Joe Mansueto, publisher
of the newly launched Mutual Fund Sourcebook,
responded to this challenge by introducing
the Morningstar fund ratings ranging from 1 to 5
stars to help investors more quickly identify
funds with better records.
Joe borrowed from the academic thinking of the
time, which argued that funds should not be
evaluated over quarters or calendar years, as was
then the fashion, but instead should be
assessed based on longer periods. Joe set three
years as the minimum evaluation period
and gave greater weight to the five- and 10-year
records when available. Academics also
urged investors to consider the risk that funds took
to achieve their gains and the costs that they
imposed on investors. Costs were a significant
and challenging thing for investors to grasp,
as front-end sales charges were then frequently as
high as 8.5% and fees had recently been
complicated by the introduction of deferred loads
and 12b-1 fees. In addition, some funds
charged loads for the reinvestment of income
distributions, while others did not. At the
time, many performance evaluations simply
ignored most costs and did nothing to address the
risks a fund took.

12

Morningstar April/May 2018

The star rating thus represented a considerable
leap forward. Adding cost and risk to the
notoriously fickle element of performance was
a major improvement, as costs and risk
could be better taken from the past and projected
into the future. High-cost funds don't
suddenly become cheap. Managers who are
naturally risk-averse don't randomly start buying
dicier companies or taking big sector bets
or stretching for yield. Risk, unlike performance,
is somewhat a matter of choice. While
the star ratings didn't speak to the people behind
the performance or their process (Morningstar
would address those concerns later as it fought
for the disclosure of manager names and
incentives), the stars did present a more intelligent
starting point than the system of short-term, raw
performance screens they replaced.
From their introduction, Morningstar displayed
the star ratings in context with scores of other data
points. They were a reasonable place to begin
a search, as it obviously makes more sense to
focus on funds that have demonstrated success-
and then to dig deeper to see if there is reason
to expect the success to continue-than it
does to concentrate on funds with poor performance, high costs, and high volatility on
the hope that they may correct those flaws.
Moreover, Morningstar consistently spoke of
the stars in sober terms, trying candidly to describe
both their advantages and their limitations.
The stars are a starting point, not a conclusion-
a grade, not a prediction.
Nevertheless, some observers insist on evaluating
the stars as predictions. Multiple popular
and academic studies explore the predictive power
of the stars. Most find the stars to be precisely
what Morningstar itself has long said-the stars
are mildly predictive. In 2016, we removed
the load adjustment from the calculation, as
empirical data suggested that few investors were
paying these loads anymore. But because
long-term returns and ongoing expenses have
a negative correlation, the stars still effectively tilt
investors away from high-expense funds,
and they modestly up the odds of good investor
outcomes. Not bad for a first-stage screen.
Still, it's fashionable for advisors to disparage the
stars, often offering their preferred alternatives

as a better path. "Just buy low-cost index funds"
and "just buy funds from a favored provider
like DFA or American Funds" are popular advisor
refrains. Invariably, however, these alternative
approaches correlate strongly with what the stars
already tell investors. Low-cost, broad-market
index funds have consistently held above-average
star ratings, as have the DFA and American
Funds groups. The stars can hardly be misleading
investors if they suggest the same conclusions
their critics urge. I've met many advisors
who deride the stars, but I've yet to meet one
whose own recommendations don't skew
toward higher star ratings. Few if any people build
consistently winning portfolios out of 1- and
2-star funds.
Moreover, these critics overlook perhaps the stars'
greatest benefit. The stars, by rewarding better
long-term, risk-adjusted performance, encourage
more prudent behavior among managers.
They create precisely the incentives that a rational
investor would desire their manager to have-
a focus on the long term, pressure to lower costs,
and disincentives to take wild risks.
Schools don't assign grades to help future
employers identify the best hires; schools
assign grades to motivate better student behavior.
So, too, do the stars discipline managers
to behave in a more shareholder-friendly
manner. In effect, the stars shift performance
evaluation from something fund managers
crave-a tool to promote short-term sales while
camouflaging costs and risks-into something
that investors and their advisors want-
incentives for greater prudence and predictability
in the management of their assets. That's a
5-star outcome. K
Don Phillips is a managing director with Morningstar. He is
a member of the editorial board of Morningstar magazine.



Table of Contents for the Digital Edition of Morningstar Magazine - April/May 2018

Contents
Morningstar Magazine - April/May 2018 - Cover1
Morningstar Magazine - April/May 2018 - Cover2
Morningstar Magazine - April/May 2018 - 1
Morningstar Magazine - April/May 2018 - 2
Morningstar Magazine - April/May 2018 - Contents
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