The 5-Star Kiss of Death

In his paper “The Kiss Of Death: A 5-Star Morningstar Mutual Fund Rating?”, appearing in the second quarter 2005 issue of the Journal Of Investment Management, Matthew Morey examines the performance of mutual funds immediately after first achieving a Morningstar 5-star rating. Focusing on diversified domestic stock funds from July 1993 to July 2001 (273 funds), he concludes that:

• During the 3 years after first receiving a 5-star rating, fund performance declines severely.
• After receiving an initial 5-star rating, the risk level of a fund typically rises substantially. Perhaps winning fund managers gamble to pre-empt gambling by losing fund managers.
• After receiving an initial 5-star rating, the fund manager tends to emphasize value stocks more and momentum stocks less. Large cash inflows that accompany the high rating may make it difficult for fund mangers to play unobtrusively in momentum stocks.
• The expense ratio and portfolio turnover are flat to slightly declining after a fund receives the 5-star rating.

In summary, portfolio changes after achieving the Morningstar 5-star rating hurt fund performance, and investors should be cautious about using this rating as the principal means of selecting mutual funds. Handling large cash inflows attracted by the high rating may be the culprit.

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