The Problems with MorningStar’s Mutual Fund RatingsJanuary 17th, 2013 by David Waring
If you are like most investors, your primary concern when choosing a bond fund is how that fund is going to perform after you invest. This is why for the millions of investors who rely on the popular Morningstar ratings system, the following quote may come as a surprise:
“The star rating is a grade on past performance. It’s an achievement test, not an aptitude test…We never claim that they predict the future.”
Don Phillips, President of Fund Research at Morningstar
I took that quote from an article written by Mike Phillips over at the Oblivious investor. As he and other investment bloggers have pointed out, MorningStar doesn’t actively try to hide the fact that Morningstar ratings are only a grade on past performance. What they also point out however, is that Morningstar does not go out of its way to make that point clear either. In fact I think if you asked the average investor, the large majority would say that Morningstar ratings are meant as an indicator of the future performance Morningstar thinks you should expect.
How LB Ratings are Different from Morningstar Ratings
Unlike Morningstar Ratings, LB Ratings are designed to give investors insight into how a fund is going to perform in the future. Does this mean that we do not look at many of the same factors that go into Morningstar ratings? No.
Often when analysing investments you will see the disclaimer “past performance is not indicative of future performance”. While I don’t know if its compliant with SEC regulations, I prefer to say that “past performance is not necessarily indicative of future performance”. In my opinion it is incorrect to say that looking at a fund’s past past performance, and the market conditions under which that performance was generated, should give you no insight into how that fund will perform under similar conditions in the future. (You can read more about evaluating a fund’s past performance here).
That is why, like MorningStar ratings, LB Ratings do place a heavy emphasis on the past performance of a fund. The difference is that when we look at past performance we also look at:
1. Past Market Conditions. We look at past performance through the lense of what market conditions were when those returns were generated. How did the fund perform during times of extreme market duress like the 2008 financial crisis and why? Similarly, how did the fund perform when the market was doing well like we saw in 2009.
2. Current Market Conditions. An understanding of the fund’s past performance and the conditions under which that performance was generated should give us a good idea of how the fund may perform under similar scenarios in the future. For example, long duration bond funds like the PIMCO Long Duration Total Return Fund are designed to perform well when interest rates are falling. Because interest rates have fallen dramatically since this fund’s inception, its historical performance has been stellar. However, now that rates are at historical lows, the likelihood of them falling much further is slim. Even though this fund has a great historical track record, its chances of repeating that performance in the future are slim.
3. How the Fund has adjusted: The PIMCO Long Duration Total Return Fund is a long duration bond fund, so its hands are somewhat tied in terms of how much it can adjust the fund’s holdings to fit the current market environment. Other funds like the DoubleLine Total Return Fund however, have much more flexibility. By looking at MorngingStar’s data on the fund, we can see that the fund currently has a duration of around 1.5, which is much lower than the category average. This means that the DoubleLine Total Return fund has brought down its duration and interest rate risk as a result of interest rates being at historical lows. (You can read more about the Doubleline Total Return Fund here)
4. Manager Tenure. For actively managed funds, we feel that past performance is less reliable if that performance was generated under a manager that is no longer with the fund.
The Bottom Line
While we still believe that Morningstar ratings provide value to investors, it is important to realize that their primary purpose is to give a grade on past performance. If you are looking for a rating system which combines many of the same factors as the Morningstar rating system, but also looks at how the fund may perform in the future, then LB Ratings are the superior choice. See all of our ratings here.