MUTUAL FUND RATINGS: DO THEY REALLY MATTER? Philip S. Russel Philadelphia University, USA 2006 PBFEA Conference, Taipei, Taiwan Research Funded by: Lindback Foundation

Agenda 1. Introduction 2. Motivation 3. Research Questions 4. Morning Star Rating Methodology 5. Data 6. Discussion of Results 7. Conclusion

Introduction Mutual Fund Industry Exponential growth from a mere $50 b5llion in 1974 to nearly $9,000 billion in In USA, the number of mutual funds exceed the number of stocks listed on organized exchange, making the selection of mutual funds an onerous task for average investor.

Role of Rating Agencies How can investors screen thousands of funds? One option is to rely on some kind of rating services Ratings provide a composite measure of mutual fund performance Currently being provided by Lipper, Value Line and Morningstar. Morning star is the most prominent.

2. Motivation

Ratings and Fund Flow While Morningstar does not claim to forecast performance, anecdotal and empirical evidence suggests that investors are increasingly relying on mutual fund ratings to make their investment decisions. 97 percent of the money invested in no-load equity funds flowed into funds with four or five star rating (Wall Street Journal, 1996) 5 Star funds claim 50.5% of all assets of domestic equity funds (Keenan, 2002) Based on 3,500 funds and 12,000 rating changes, Guercio and Tkac (2002) report causal relationship between rating and fund flow.

Thus predictive ability of morning star rating system is an important question as ratings have become extremely popular and seem to significantly influence the allocation of investment dollars.

3. Research Questions

Research Questions 1. Performance: Does picking 5-star funds lead to superior performance? 2. Persistence: How persistent are the ratings? Does the degree of reliability vary among the groups? That is, is a 5-star rating more reliable than a 3-star rating in forecasting future performance? 3. Star Attributes: Are there any distinctive differences among funds, based on their rating category? 4. Age Bias: Is there an age bias in rating?

4. Morning Star Rating Methodology

Morning Star Rating Methodology Mutual funds are classified into 48 investment groups. Until 2002, there were only 4 groups - domestic equity, international equity, taxable bond, and municipal bond Ratings recognizes the performance within each group based on historical risk and return measures. Based on monthly data, ratings assigned for 3,5,10 years and also “overall rating” based on weighted average of 3,5,10 year ratings. The Stars RankStars Top 10%5 Next 22.5%4 Middle 35%3 Next 22.5%2 Bottom 10%1

Biases in Rating Load versus No-load Rating biased in favor of no-load funds Morey (2002) reports that out of 164 funds receiving 5-stars, 75% were no-load funds Age of Fund Rating favors new funds due to surviorship effect (Blume, 1998) Rating favors seasoned funds due to weighting system (Morey, 2002) Seasoned funds regress towards the mean due to interaction between age of fund and fund size (Adkisson and Fraser, 2003)

5. Data

Data Source: Morningstar Principia Morning star changed the rating methodology in July 2002 Current study based on quarterly data for 2003 for growth funds. QuarterNumber of Funds I1811 II1915 III1996 IV2074

6. Discussion of Results

6.1 What are the attributes of Winning Funds? Reference: Table 4 5-star groups are clearly “winning funds” Star5-year Ret% 15 year Ret% Beta 1-Star-4.85% Star All funds

Attributes of Star Categories Attribute1-Star5-Star Alpha Turnover Tenure Expense Ratio Asset Size

6.2 Is There an Age Bias in Rating? We first divide the sample for each quarter into three groups: Large Cap, Medium Cap and Small Cap We further divide the sample based on their age, in years: Seasoned funds (age ≥ 10 years), Middle-aged funds (5 ≤ age age ≥ 3) We then test for differences in overall rating between Seasoned Versus Young funds, Seasoned versus Middle age funds, and Middle age versus Young funds. ==> 9 times 4 = 36 inter-group comparisons

Of the 36 inter-group comparisons, only 7 are statistically significant. Thus Morey’s (2002) contention that seasoned funds systematically receive higher overall rating is not observed.

6.3 Is there a Persistence in Rating? Short-Term Persistence in Rating Ratings for March compared with June/September/December ratings Funds matched by name 1692 identical funds for March Versus June 1522 identical fund for March Versus September 1195 identical fund for March Versus December

Very few funds maintain their rating and persistence deteriorates. The following table shows March Versus December Stars# of funds 3/30 Mean 12/30 mean # same star All (52%)

7. Preliminary Conclusion

Preliminary Conclusion Does Morning Star Rating Really Matter? No. Investors are interested in future performance and results show that very few funds maintain their “star rating”. Thus ratings should not matter! The continued aggressive promotion of ratings in advertisements may indeed foster a “false” sense of confidence among naïve investors (who seem to ignore Morningstar disclaimer that stars do not reflect future performance) Buyer Beware!

In progress: Expansion of results to bigger database (2003, 2004, and 2005). Refining the measurements of risk and return to assess performance. Application of decision making/forecasting models.