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Morningstar Ratings and Future Returns

Posted in Investing Expertise, Mutual/Hedge Funds

Does the Morningstar mutual fund rating system work? If so, how? In their March 2009 paper entitled “Selectivity, Market Timing and the Morningstar Star-Rating System”, Antonios Antypas, Guglielmo Caporale, Nikolaos Kourogenis and Nikitas Pittis investigate whether Morningstar mutual fund ratings enable investors to select funds that are likely to outperform in the future. Using data for 1,511 rated equity mutual funds since January 1998, they conclude that:

  • Raw returns of portfolios of equity mutual funds constructed based on Morningstar ratings increase consistently with the rating from 0.31% per month for one-star (lowest rated) funds to 0.51% per month for five-star (highest rated) funds. (See the chart below.)
  • However, the portfolio of five-star funds has the second highest volatility of monthly returns of the five portfolios.
  • More detailed analyses suggest that the portfolios of three-star, four-star and five-star funds exhibit some stock picking ability.
  • Overall, evidence suggests that the Morningstar rating system is useful for identifying underperforming (one-star and two-star) funds, but not for discriminating among three-star, four-star and five-star funds.

The following chart, constructed from data in the paper, compares the average monthly raw returns and variabilities of equally weighted portfolios of mutual funds constructed based on Morningstar mutual fund ratings (worst=one star to best=five stars) since January 1998. Returns increase consistently with ratings, but the portfolio of five-star funds is the second most volatile.

In summary, the Morningstar mutual fund rating system can probably help investors avoid funds with the worst future performance.

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