Why Morningstar ratings matter
Morningstar is best known for helping investors decipher the past performance of mutual funds and which managers and their products are worth looking at. While the company distills its historical screens into easy to understand star rating (1-5 stars with 5 being the top performers) its process is more complicated and the results of its screen do effect the fund managers involved. Historically, once Morningstar screens are tabulated and released, it is only the very top echelon of funds that actually get new fund flow from investors with the lesser rated funds historically experiencing a consistent outflow of customer money.
Morningstar’s ratings are based on a mutual funds relative performance within a category, for example large cap growth stock funds, over the past three, five, and ten year periods. Sales fees are then subtracted from a fund’s return and then a risk assessment is made on how those returns were generated. Volatility within the fund is generally the most common risk assessment made and funds with low volatility are rewarded against other funds with higher volatility, which are penalized. The end result from Morningstar is a score that reflects each fund’s risk and fee-adjusted returns.
Funds are then ranked based on these scores with the top 10% of funds awarded a five star ranking, the next 22.5% of funds getting four stars, the middle 35% getting three stars, the next 22.5% two stars, and the bottom 10% one star. Finally, a combined star rating is formulated for the three, five, and ten year performance for each fund. The combined star rating is weighted 50% by the fund’s 10 year result, 30% for the 5 year result, and 20% for the fund’s 3 year result.
Historically the results of these ratings have not been taken lightly by investors because they have influenced investment flows. Looking at 12 years worth of flow data into and out of Morningstar ranked funds, shows that only the top rated or 4 and 5 star rated products generate new investor interest (or money flow into the fund). Conversely, funds ranked 1, 2, or 3 by way of Morningstar’s rating process have had outflow in every year (as seen below from 1998 through 2010). For example in 2010, all 4 and 5 star Morningstar rated funds experienced $141 billion in new investor inflow. This compared to all 1-3 star products which had outflows totaling $16 billion. This dynamic of inflows for the top funds and outflows for bottom funds, was consistent in all 12 years of our study.
Thus when Morningstar releases its new composite ratings, investors should pay attention as to which public fund managers did the best as it historically has translated into new assets for the fund family and as a result these respective asset manager stocks may prosper. The biggest public fund managers are BlackRock (BLK), Franklin Resources (BEN), and Legg Mason (LM).
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