John Gorlow
| May 08, 2018
It’s human nature to compare products, especially when money is involved. We’ll spend hours and even days poring over ratings for cars, washing machines, restaurants and vacations. How about picking a mutual fund? For that, millions of investors and their advisors rely on Morningstar’s five-star rating system. Does it work? Yes, but not the way you might think. This month we offer our own rating of the Morningstar juggernaut. First, a review of the April numbers.
April Market Report
The S&P 500 posted a modest 0.38% gain in April, reversing two previous months of declines, including a broad negative -2.549% return in March and -3.69 in February. Year-to-date returns on the index remained in the red, down 0.38%. Over the one-year period the index returned 13.27%, which is much higher than its historical average.
The S&P Small Cap 600 continued its advance, posting a 1.03% return in April after returning 2.04% in March. Over the one-year period, the S&P Small Cap 600 returned 12.82%, with the five-year annualized gain at 13.85%—besting the S&P 500. From a style perspective, the results were mixed. For April, small value outperformed small growth, whereas large growth outperformed large value.
International developed markets started to pull back in late January after a strong month (+4.66%), continued to do so in early February (-4.75%), began to stabilize with smaller losses in March (-1.73%), then turned positive in April with a 2.3% return. All of this combined to leave international developed markets with a slightly positive YTD return of 0.21%.
While global developed markets were higher in April, emerging markets did not do as well, posting a negative -0.44% April return after March’s broad -1.27% decline and February’s -4.1% negative return; however, they remained in the black YTD, up 0.97%. Their one-year return was 21.71%. Over the two-year period, emerging markets returned 20.42% per annum and their three-year annualized return was 6%, which was below its long-term average.
Global REITs continued their upward momentum after a sluggish start to the year. Domestic REITs returned 1.48%, while international REITs returned 1.65%. For the trailing twelve months, international REITs returned 10.02%, significantly outperforming US REITS, which returned negative -2.02% over the same time period.
The 10-year U.S. Treasury Bond crossed and closed above the 3% level, but it closed the month at 2.95%, up from last month’s 2.74%. Oil closed the month at USD $68.45, up 5.4% from March's USD $64.96. Gold was down for the month, closing at USD $1,316.10 from $1,329.40 for March. High yield bonds were the best performing category in April and for the one-year period, returning 0.65% and 3.26% respectively. The Bloomberg Commodity Total Return Index posted a healthy 2.58% return for April, and a solid 8.02% return for the trailing twelve months.
Feature Article:
The Morningstar Machine
Morningstar has been the undisputed king of mutual fund ratings for decades. Millions of investors believe a five-star rating equates with a “buy now” recommendation. And yet the company denies that its star system is meant to be predictive. Who are they kidding? What fool would buy a one-star fund when a five-star choice is available?
A comprehensive November 2017 Wall Street Journal study (The Morningstar Mirage) opened a Pandora’s box of issues that mutual fund investors would be wise to consider. Upon examining the performance of thousands of Morningstar-rated funds dating back to 2003, the Journal found:
• Just 12% of the funds with a five-star rating did well enough to retain that rating over the next five years.
• Most five-star funds averaged three stars five years later, and 10% did so poorly that they plunged to the bottom with a one-star rating.
• Domestic stock funds (the largest category of U.S. funds) fared even worse. Only 10% of these funds held on to their five-star rating over the next three years, 7% for the next five years, and 6% for ten years. In other words, a five-star domestic stock fund is a near-certain road to disappointment.
But don’t talk about disappointment to the fund managers, discount brokers, advisors and consultants who rely on Morningstar data to woo clients into high-fee funds. To these folks, the star ratings are pure gold. We’ll get to that in a moment. First, a little background on the Morningstar model.
Morningstar was founded in 1985, just as mutual funds exploded in popularity. By the 1990s, the star system and “superstar” fund managers were closely entwined. The star system has been tweaked over time, but remains quantitative, based on a “Morningstar Risk Adjusted Return” that includes a monthly calculation of historical returns and volatility. Funds are compared to others in their category, and awarded stars for trailing 3, 5 and 10-year periods. In 2011, Morningstar added a second “qualitative” rating system, an analyst scorecard that declares funds gold, silver, bronze, neutral or negative based on five factors including investment process, performance, fund manager, parent firm and current price.
Star Attractions
If Morningstar can be construed as a tool, what is its purpose? The answer can be found in who’s buying it, using it, and making money from it. According to the Wall Street Journal study, “Nearly every asset manager in the world pays Morningstar for data services. Some 250,000 financial advisers rely on Morningstar’s data, service or ratings.”
Got that? These folks are paying Morningstar for backwards-looking data, then using it to influence investment decisions for hundreds of millions of people in retirement plans, pension plans, brokerage accounts, wealth management services, bank investment branches, trusts and more. Morningstar, it turns out, is a money-making machine for the funds it ranks and the salespeople who package and sell those funds.
To illustrate that point, consider what happens when a fund achieves a five-star rating. It grows. Fast. The WSJ found that investors “put new money into five-star-rated funds in 69% of the months [during which] it held that rating.” Research by Strategic Insights found that Morningstar’s four-and five-star funds “showed net positive inflow every year between 1998 and 2010. Conversely, funds rated average or poor, at between one and three stars…showed net negative investment flow over the same period (Sean Ross, Investopedia).” The lesson is hard to miss. If you’re a fund manager, you better court Morningstar.
Many funds do just that, sending portfolio managers to Morningstar to tout their experience and management teams. Morningstar’s analyst ratings are overwhelmingly positive, according to the Journal: Between November 2011 and August 2017, just 5% of 9,200 fund classes received a negative review. By the end of August 2017, negative reviews dropped to 1%. Which begs the question, how bad do you have to be to get a negative review?
For some funds, especially smaller ones, earning Morningstar’s highest rating is a double-edged sword. The Journal article referenced above points to the example of Buffalo Emerging Opportunities, a smallish fund that saw its assets quadruple in just five months after receiving its fifth star. Unable to keep up, the fund closed to new investors six months later. Then a losing streak set in. Its Morningstar rating subsequently fell to two stars and assets fell from $400 million to below $100 million. Similar stories can be found throughout the fund world.
Making Bank
Keep in mind that regardless of a fund’s future performance, every salesperson, broker and analyst who sells investors into a five-star fund makes money. For them, selling stars is money in the bank. Discount brokerages market five-star Morningstar funds, advisors package them for gullible clients, and pension fund advisors invest in them based on their broker’s advice. Morningstar ratings are a marketing machine, one that investors respond to without full understanding. Perhaps those investors would hesitate if they understood that five stars earn piles of money for Morningstar, the funds, and all the middlemen grabbing a piece of their investment pie.
What’s Not in the Stars
Let’s put aside obvious conflicts of interest to consider other downsides of Morningstar ratings.
This year’s winner, last year’s dog. Actively managed funds can shift into and out of Morningstar categories based on market caps or price/earnings multiples. “Some funds get coveted four- and five-star awards because they are in less competitive categories,” a Forbes article observed way back in 2005 (Serchuk and Cash). Fund managers deny gaming the system, but obviously it can happen. Worse, it’s hidden. “Investors interested in tracing the category history of a meandering fund are out of luck,” the article explains. Morningstar doesn’t provide that information.
Fund expenses matter. Multiple studies prove that fund expense ratios are a better predictor of performance than stars. Russel Kinnel of Morningstar set up a controlled study in 2010 that concluded “in every asset class over every time period, the cheapest quintile produced higher Total Returns than the most expense quintile.” He concluded that “Investors should make expense ratios a primary test in fund selection. They are still one of the most dependable predictors of performance.”
Where’s the index comparison? Samuel Lee, a former Morningstar fund analyst, notes that “the practical choice facing investors is not between an active fund and its average or median peer, but between an active fund and an appropriately matched investible index fund (Mutual Fund Observer, “The Real Problem with Morningstar’s Star Rating”). After all, “a fund that beats its peer group but not its logical index is still a loser as far as the investor is concerned.”
You’re being sold. But you don’t have to buy.
Who needs Morningstar and its five-star model? Not you. The real clients, the ones with deep pockets, are the brokerage firms and banks that develop high-fee products supplemented by Morningstar ratings to validate their offerings and justify their fees. They cleverly give the impression that they are acting in people’s best interest by serving up Morningstar as an independent, objective investment authority and yet it’s just a mirage.
But don’t take my word for it. Listen to Samuel Lee, the former Morningstar employee:
“If you walk into a bank or brokerage and ask for financial advice, a salesperson (who will call himself an advisor or wealth manager) will steer you into pricey, mediocre proprietary products. This salesperson will have some rudimentary investment knowledge, but he will mostly be regurgitating whatever sales scripts were given to him to push the firm’s model portfolios. (These models, by the way, are designed to hit that sweet spot of looking complicated enough for clients to feel as if they’re getting value for their money, but not so unconventional as to lag the benchmark by much.)
Most people calling themselves financial advisors are salespeople, not technical experts. This wouldn’t be a problem if not for the fact that many misrepresent their expertise. There’s even a lucrative sub-industry of phony qualifications and awards for financial advisors, such as the “Five Star Professional” designation that mostly signals the advisor is enough of a huckster to pay for a phony award.
If 80% of the least competent and honest advisors disappeared and were replaced by index funds, the world would be better in almost every way. I’ve seen how billion-dollar registered investment advisors, the wealth-management units of major banks, and small-time brokers manage money. The better ones offer overpriced closet index strategies; the worst ones cheat their clients.”
Couldn’t have said it better myself.
In sum: Choosing funds based on backward-looking data is ridiculous. We can’t know how the best stocks will perform tomorrow, much less how a mutual fund filled with a mix of those stocks might do. Picking expensive five-star funds is not a profitable long-term strategy. Relying on pricey brokers and bankers for investment products is an invitation to be ripped-off. Low-priced, transparent indexing guided by a fiduciary with appropriate diversification for goals, risk and age is the way to go. Keep it simple. Don’t look to the stars, but to time-proven strategies and independent objective and unbiased advice.
Do you have questions or concerns? Call me, I am here to help.
Regards,
John Gorlow
President
Cardiff Park Advisors
888.332.2238 Toll Free
760.635.7526 Direct
760.284.5550 Fax
jgorlow@cardiffpark.com