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 Don't be starstruck - Eureka Report article 

Don't be starstuck

By Scott Francis
June 2, 2010

PORTFOLIO POINT: The ‘star system’ used to rate managed funds is not necessarily the safest guide for investors.

With more than 10,000 managed funds in the Australian investment landscape – outnumbering stocks listed on the ASX – rating agencies play a vital role in helping investors sort the good from the rest. A good rating can lead to a fund being included on the list of “approved products” that financial planners are allowed to recommend.

During the GFC key investment rating firms made grave errors that miscommunicated the risk of investment products built out of US mortgages. These investments were rated as being very safe (AAA), a rating relied on by sophisticated institutional investors such as the National Australia Bank, before they had to write down nearly $1 billion on their investment.

More recently, in Eureka Report editor James Frost broadened the scope of examinations of our flawed financial ratings system when he found often severe faults in the rating of investment products, especially in the superannuation industry (see Time to junk the rating system).

At this juncture it is only logical to the examination further: the much vaunted star system for investment products must now be put under microscope. We see the number of stars a product has received from ratings agencies highlighted in the media. It is not unusual to see full-page advertisements for products that have scored particularly well … but what does it all mean?

A starting point might be an academic paper written by Sawicki and Thomson. Using an agency’s recommendations from 1989 to 1995, they created portfolios of “approved” and “non-approved” stocks. The “non-approved” portfolio performed slightly better.

Their conclusion was clear: “The results generally reveal no significant difference between the performance of approved and non-approved funds on a group as well as an individual basis, suggesting that the classic return-maximising investor would not be aided by the research companies’ recommendations.”



As for the “stars”: One Australian study specifically looked at Morningstar, the market leader in the rating of investments well known for its iconic “five star” system of rating funds. Paul Gerrans wrote the paper Morningstar Ratings and Future Performance, published in 2006 in the Journal of Accounting and Finance, and used several performance measures to look at the effectiveness of Morningstar ratings.

He concluded that “overall, the evidence does not support the view that five-star funds will subsequently outperform lower rated funds”. It is worth noting that this paper considered both the qualitative and quantitative research produced by Morningstar.

The importance of the fund rating process for investors is shown in a 2002 study The Effect of Morningstar Ratings on Mutual Fund Flows by Del Guercio and Tkac. They found that a five-star Morningstar rating increased investment flows into a fund by more than 50% from usual.

This is great for a fund manager (who works on a percentage fee and is therefore increasing their fee for every extra dollar invested in their fund), but it might not be so good for investors. The increased money in the fund may make it more difficult for the fund manager to invest.



For example, rather than putting money into their 10 best investment ideas, they might have to invest in their 20 best ideas. Further, rather than investing $2 million in a company they might have to invest $4 million, pushing up the price of the shares as they take a position, creating a greater market impact for their trading activities.

What’s more, a larger pool of money makes it increasingly difficult for a fund to invest in smaller companies, forcing them to narrow their focus to large companies.

The impact of a Morningstar five-star rating is considered in the paper The Kiss of Death: A 5-Star Morningstar Mutual Fund Rating? by Mathew Morey published in the Journal of Investment Management in 2005. He finds that after being awarded five stars, funds posted a sharp drop in their three-year returns, falling below the average market return for three of the four performance measures.

Given that we have focused on research that considers the Morningstar ratings system, it is worth looking Morningstar’s own website as to how it manages expectations the fund rating system. It says “the star rating serves as a reasonable way to narrow the universe down to a subset of funds with strong records of performance”. Given the size of the managed fund market, this would appear to be quite a useful service for investors – although much research suggests that past performance does not lead to future outperformance. In fact, this is emphasised by Morningstar, which says “the past doesn't reliably predict future returns”.

Given that the Morningstar ratings are based on past returns, adjusted for risk, caution should be shown in assuming that a high star rating will lead to superior future fund returns.

Conclusion

The search for information is a challenge for investors. Agencies that rate investments act as important gatekeepers of information, but the process of rating funds and the future performance of funds after receiving high ratings is not without its challenges. After all, if successful investing was a simple matter of investing in those funds that had posted high performances in the past we would all be millionaires many times over. It isn't and we aren't – so we have to keep sorting through the information we have at hand as best we can, to make the best decisions possible.
Scott Francis' articles in the Eureka Report 

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