Blog - Investing Notes

March 23, 2006 - The Morningstar Mutual Fund Rating System Works?

Can investors count on the widely cited Morningstar mutual fund rating system as an investment screener? In their recent paper "Morningstar Mutual Fund Ratings Redux", Matthew Morey and Aron Gottesman investigate the relationship between number of Morningstar stars and future performance of mutual funds since June 30, 2002, when Morningstar overhauled their rating system in terms of granularity, risk measurement and treatment of share classes. Focusing on the three-year performance of domestic equity funds that were rated by Morningstar as of 6/30/02 (1,902 funds) and adjusting for fund loads and survivorship bias, they conclude that:

• In general, high-rated funds significantly outperform low-rated funds over the next three years.
• This performance is monotonic, with each incremental star indicating an increased level of future fund performance.
• A momentum effect, with money flowing into (out of) highly (lowly) rated funds and therefore into (out of) the stocks they hold, may help explain this predictability.

In summary, the Morningstar mutual fund rating system offers value to investors seeking funds for outperformance over the next few years.

For related research, see Blog Synthesis: Mutual Funds and Hedge Funds. See especially our blog entry of 5/1/05 examining the behavior of funds after achieving a 5-star Morningstar rating.