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Have Mutual Fund Rating Agencies Lost Their Mojo?

January 15
01:19 2013

Late last year, we ran a story titled “Why 401k Plan Sponsors (and Investors) are Going Back to the Future,” (, December 4, 2012). The premise of that article stated that plan sponsors and 401k investors have begun to return to the days of the single managed portfolio as a preferred option. This move is consistent with findings (as well as normal intuition) that suggest professional managers are better at managing portfolios than the average man on the street. In a single managed portfolio, the professional determined when and where to move from cash to bonds to stocks, when it’s more appropriate to invest in domestic vs. foreign securities and when to invest in what market caps. It’s old style. It’s imperfect. But, to paraphrase what Churchill said of democracy, “it’s the worst alternative except for all the others that have been tried.”

This trend, then, leads to two rather interesting sets of circumstances, one of which we’ll address here. First, the gradual movement of retirement investors towards a single managed portfolio (whether that means a target date fund, lifestyle fund, balanced fund or just an all-equity multi-cap fund it not important for this point), means the gradual disintermediation of an entire tier of professional service providers. This tier includes what we’ll call “secondary” advisers (an ironic nomenclature given they are often on the front line with the clients). They’re “secondary” because these individuals “manage” the actual managers of the money. They don’t manage the money themselves. In the era of the rise of the Morningstar Style Box, we saw a rise in these types of professionals. Now that the Style Box is on the wane, the “primary” managers will likely return to the forefront. This trend will likely cut the total cost to investors.

But that’s fodder for another story, one that will take longer to develop.

Of more immediate relevance – something we are already seeing – is the second consequence of this drive of retirement investors toward a single portfolio (again, the type of single portfolio doesn’t matter right now). This consequence calls into question the very relevance of current mutual fund rating services. We’ve already alluded to this above when we mentioned the fall from prominence of the Morningstar Style Box. As you’ll soon discover from the comments of professional advisers that follow, while it’s clear the mutual fund rating services may have lost their mojo, it’s not necessary certain an alternative has yet surfaced.

By far, Morningstar, attractively priced for both retail and professional investors, remains the most popular mutual fund rating agency even though Lipper is the largest and oldest aggregator of mutual fund data. As a provider of raw data, though, Lipper has been the mainstay of academic and professional studies. Lipper recently added a rating service similar to Morningstar’s star ratings called Lipper Leaders. Unlike Morningstar, which at least initially relied heavily on Modern Portfolio Theory to develop their well-known Style Box system, Lipper has utilized more of the facets of behavioral finance to develop their rating system.

Professional advisers are generally familiar with both rating agencies, as well as a few other minor alternatives like BusinessWeek, and Barron’s. Many, however, no longer utilize these rating services the way they were intended. Todd Tresidder, a financial coach at FinancialMentor.Com in Reno Nevada says, “I don’t use any rating agencies except for basic research and to locate funds by category. The reason is simple. The only thing that matters when picking a fund is future investment performance, and none of the ratings provide useful indications of future performance. In fact, Morningstar was honest enough to state exactly that in a recently published article on their site where they pointed out that their proprietary star rating system is not a valid indicator of future investment performance or even relative performance. “

Joshua Ziering, Director of Marketing at FutureAdvisor in San Francisco, says his firm uses “Lipper for information about funds, but doesn’t utilize any of their rating metrics.”

“I am familiar with Morningstar and Lipper,” says Tim Dyer, Vice President of Sage Capital Advisors, LLC in La Jolla, California. But, he adds, “I rarely use either, except to pull the fund fact sheets and look at some things like management fees, performance and occasionally some holdings etc. There are no advantages of using either since they are based entirely on past performance which has zero influence on the future.  The [Morningstar] star rating system is one of the most flawed use of our investors time. In fact studies show that if you did the opposite of the rankings or purchased the lowest ranked funds from the year before your returns would have been higher historically over time.”

Clearly, the services do have value as warehouses of data. “The advantage of Morningstar is that all the information is succinctly presented. ,” says Timothy R. Yee, AIF, co-founder, Green Retirement Plans in Oakland, California. James W. Watkins, III, CEO of InvestSense, LLC in Atlanta, Georgia agrees and even goes a step further. He says, “For my practice, Morningstar’s advantages are extent and quality of information, as well as outstanding analytical tools on their website.”

As far as the rating system goes, Elle Kaplan, CEO & Founding Partner at Lexion Capital Management LLC in New York City offers this blunt (and somewhat topical) point: “Studies show that as soon as a manager has a 5 star rating the mean reverts. Using ratings agencies is like picking the last 5 winners of the Super Bowl to determine the next champion. It does nothing to tell us who the next 5 will be.”

But Morningstar may have more problems than just its rating system. Yee says, “Morningstar sometimes put funds in the wrong category (apples v oranges comparison). Ditto to comparing it against peers that are not really peers. For example, should an alternative energy fund really be compared against one that invests in oil/ fracking?”

Michael T. Prus, President of Scale Investment Group, LLC in White Lake, Michigan, says, “The lack of a Multi-Cap category is merely one example of funds being compared on a non-apples-to-apples basis. Often funds are mis-categorized, or categorized in a ‘best fit’ category which may not be all that good of a fit at all (some funds are just not easily categorized and comparing them with certain categories can lead one to believe things that are inaccurate).”

Many advisers would like to see Morningstar incorporate a multi-cap fund category in their listings. Rich Winer, President of Winer Wealth Management, Inc. in Woodland Hills, California, says, “I think it would be very beneficial for them to include a multi-cap category. It seems like Morningstar is most comfortable with defined styles. For example, small cap managers generally have a predominately small cap portfolio. So people can compare apples to apples. With a multi-cap fund, it could be overweighted in any particular area depending on the way things go in the portfolio and the market. Multicap is kind of like a balanced fund. While advisors will often look to find the best managers in different areas of the market, people with fewer funds to invest may want fewer funds. An all cap fund can fit the bill just like a balanced fund. Also, even if I have good funds in the small, mid and large cap area, I might also like a good all cap fund to round things out.”

Leave it an academic, though, to read the fine print. David Nanigian, Ph.D. and Assistant Professor of Investments at The Richard D. Irwin Graduate School of The American College in Bryn Mawr, Pennsylvania told that Morningstar, in fact, does have a multi-cap category. It’s called “All Cap” and it was listed in their Morningstar Institutional Categories (for portfolios available for sale in the United States). While this paper was published in 2012 with an effective date of April 30, 2012, the current version of Morningstar Principia does not include an “all cap” category. Unfortunately, Mr. Nanigian’s comments reached us as we were going to press and we did not have time to contact Morningstar about this apparent discrepancy. We’ll add any new information we find as an update to this article if we receive any.

There are, however, two important comments we’d like to leave readers with. The first comes from Prus, who says, “I don’t want to seem rough on Morningstar or Lipper or any other company that tries to categorize and summarize funds, as it’s far from an easy task, but one needs to understand the limitations of these services. In my opinion there is no replacement for doing your own due diligence and speaking with fund management one-on-one to understand the fund, its people and investment process inside and out.”

Along the same lines, and perhaps summarizing the feelings of many investment advisers, is Robert Massa, Chief Investment Officer at Ascende Wealth Advisers in Houston, Texas, who says, “While I access Morningstar, Lipper and ValueLine for data, I do all of my own research and due diligence on top of their work. Their data and databases are useful for extracting and preparing reports. While I find their research useful for a fund I am unfamiliar with, their research lacks the basics. Morningstar categorizes everything into style boxes, but many funds these days don’t fit in the traditional style box anymore. I find Lipper’s asset classes more flexible than Morningstar’s. But there is nothing like calling and talking to a portfolio manager yourself. None of these services tell you how the manager is compensated. What drives them to succeed? Does it really match what you’re client is trying to do? If you have two large cap growth managers but one follows a contrarian style and the other focuses on growth stocks with high moats with unique products or services, they are not the same, but they are still in the same asset class. Only the adviser can add true color and clarity on which fund best fits the client’s objectives. The ratings services, for all their glitter and resources fail to provide the basic fundamentals that really count. For the best advisers, the ratings agencies are where the analysis begins, not where it ends.”

And, with those sage words, what better way to end this article.

UPDATE: (January 17, 2013) Morningstar does maintain an “ALL-CAP” (a.k.a., multi-cap) but it is only for its “institutional” clients (the product is called Morningstar Direct) and not their more broadly used Morningstar Principia product. Here is what Morningstar told “Regarding Principia, we developed our institutional fund category system for our institutional clients and therefore released it in our institutional software product, Morningstar Direct. We will consider making it available in our advisor products if there is enough client demand and the feedback you’re providing is very helpful.” So, you heard it here first, folks. If you want it. Let them know.

Interested in learning more about this and other important topics confronting 401k fiduciaries? Explore Mr. Carosa’s new book 401(k) Fiduciary Solutions and discover how to solve those hidden traps that often pop up in 401k plans. The book also contains a series of chapters on this subject, including how to create an investment policy statement that defines a set of menu options consistent with the “one portfolio” concept (as well as leaving room for those few remaining do-it-yourselfers).

About Author

Christopher Carosa, CTFA

Christopher Carosa, CTFA


  1. James Watkins
    James Watkins January 15, 13:59

    As usual, excellent article Chris. Great points throughout.

    As investment professional, we know that any ranking service is just a beginning point. As Mr. Massa points out, investment professionals are responsible for doing their own due diligence. This is a mistake that a lost of plan spsonsors make. The courts have held that any reliance on third party research must, at a minimum, be reasonable, with “reasonable” being defined as “independent and impartial” and “extensive and objective,” folowed-up by the fiduciary’s own due diligence.

    Morningstar is often criticicized for its star system and the pack of persistence of such rating. While the lack of persistence has been well documented, it should be noted that Morningstar has openly stated that its star system is based on past perfomance and is neither intended to be, nor should be, used as a basis for predicting future perfomance.

    Once again, excellent article.

  2. WallStreetRanter
    WallStreetRanter January 20, 14:25

    How is it that all these advisors don’t know that morningstar has more then just star ratings? They do have forward looking ratings called analyst ratings…Gold, Silver, Bronze, Neutral & Negative.

  3. Christopher Carosa, CTFA
    Christopher Carosa, CTFA Author January 21, 13:50

    WallStreetRantor: Don’t blame the advisors on that one. Blame the editor. The interviews contained plenty on the good, bad and ugly of the analyst reviews. Unfortunately, the word length had already surpassed our recommended amount and, alas, those comments were left on the cutting room floor. Perhaps, a future article…

  4. Elmer Rich
    Elmer Rich January 30, 11:31

    Recent research suggests that both administrators and employees chase performance with serious penalties.

    Significant research also suggest professional managers benefit mainly from luck. There is little evidence for skill in investment management – anywhere.

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