The Folly of Ratings

By: Dustin Barr, CFA

As humans, we are innately wired to repeat behaviors that have proven beneficial.  Our ability to adapt and learn from our mistakes informs the choices we make.

Children rely on their parents and caregivers for information that influences their decision making.  Early man used information gathered from experiences they witnessed in their village.  If one villager tried to climb a wall and fell to their death, the others likely concluded that wasn’t the best route.  As technology has advanced and connected our entire society, we too have evolved the inputs of our decision making.  The ability to aggregate human experiences through technology has dramatically changed our behavior.  A few examples:

• Sending your kids to college? Princeton review and US News can come in handy in informing your decision
• Heading out to eat? Many of us use services like Yelp to pick the best new restaurant in our area
• Planning a vacation? Services like TripAdvisor come in handy as we select desired locations, resorts, and experiences

The use of ratings, both user and professional services, is prevalent in our society and for good reason.  We are able to aggregate human experiences to inform us on making a decision that we otherwise had limited information about.  We all know that blindly following ratings services is not fail safe, but odds are the ratings will be informative and improve our experience.

In the investment industry, there are numerous services that help investors make informed decisions about investment products, vehicles, and services.  The most prevalent ratings service in the mutual fund and ETF market is Morningstar.  Full disclosure, we subscribe to Morningstar’s institutional-level research and data services to aid our research efforts.  Morningstar is best known for their star ratings metric (Lipper offers a similar service).  Calculated on prior 3-, 5-, and 10-year performance, they rank funds on a risk-adjusted basis against their peers to award an overall rating of 1 to 5 stars (worst to best).  Individual investors who use Morningstar react as expected.  The following chart shows the flow of money into and out of mutual funds and ETFs based on their star ratings.

See a pattern?  Investors (humans) are deciding to put their money with products that have provided the best results. Just like choosing a top-rated college, a 5-star resort, or the Michelin 3-star restaurant, their decision is inherently rational.

Now, here’s the bad news.  It’s proven to be a truly ineffective way to manage money.  Morningstar, to its credit, has released numerous thought pieces acknowledging its star ratings are not predictive of the future.  In fact, when Morningstar attempted to study persistence and what led to being a 5-star fund, they discovered there was very little persistence between 2-, 3-, 4-, and 5-star rated funds.  Reversion to the mean is a powerful force!  Morningstar found that fee levels were the only consistent attributor to high ratings but even fee levels weren’t predictive of 5 star rated funds.

The market is smart, and we all gravitate to the same ratings systems. Thus the best restaurants flourish, while the worst shut down.  The same is true in money management.  The challenge is that success leads to a steep increase in assets for a manager.  Now, a manager who has just experienced tremendous success is forced to put new money to work in stocks that have already performed well.  There may simply not be enough good ideas for the new cash that must be deployed.  Herd following presents an interesting paradox.  A skillful manager is rewarded with new assets (and more fee revenue), but the new assets will serve as a huge headwind for the manager’s future success.

Never has this been more evident than the case of Bruce Berkowitz and the Fairholme Fund.  Mr. Berkowitz was awarded Morningstar’s manager of the decade after generating annualized returns of +18% from 2000 – 2009.  Few will question Mr. Berkowitz’s skill or performance record over that time period.  Sadly however, when taking fund flows into account, Morningstar determined the average investor in the Fairholme Fund experienced a return of      -11%!  The average investor in Fairholme lost money!  It turned out they couldn’t stomach the Fairholme Fund’s extreme volatility.  When the Fund experienced tremendous gains, it received high ratings.  The high ratings and performance led to investors buying the fund (near peaks). When the fund experienced poor performance and its rating dropped, investors sold (near troughs).

Similar studies have been carried out by other firms, including Vanguard.  In Vanguard’s analysis, they concluded that buying an average rated fund and holding it for ten years led to better outcomes than chasing 5-star rated funds every three years.

In conclusion, ratings systems are a useful tool in almost every facet of our lives. When it comes to investing, however, chasing the top performing investment typically leads to disappointment.  Most online brokerage houses actually have a Morningstar rating screener but limit visibility to only the 5-star funds.  We seriously doubt many investors are seeking out 2-star or 3-star rated funds on their own; however, they might actually be better off doing so.  There is more to selecting investments than Morningstar ratings.  Past risk-adjusted performance is just one input, among many, that we evaluate when selecting an investment.

Dustin Barr, CFA is a Consultant & Director of Research at Carolinas Investment Consulting. He oversees the CIC Investment Committee and manager research and due diligence process at the firm.  He provides investment & financial advice to families, non-profits, and corporate retirement plans.  Click here to learn more about Dustin and how he can help you.

The views and opinions expressed in this article are those of the author and do not necessarily reflect the official policy or position of Carolinas Investment Consulting. All data sourced from Morningstar Direct unless otherwise noted.  The information published herein is provided for informational purposes only, and does not constitute an offer, solicitation or recommendation to sell or an offer to buy securities, investment products or investment advisory services. All information, views, opinions and estimates are subject to change or correction without notice. Nothing contained herein constitutes financial, legal, tax, or other advice. The appropriateness of an investment or strategy will depend on an investor’s circumstances and objectives. These opinions may not fit to your financial status, risk and return preferences. Investment recommendations may change and readers are urged to check with their investment advisors before making any investment decisions. Information provided is based on public information, by sources believed to be reliable but we cannot attest to its accuracy. Estimates of future performance are based on assumptions that may not be realized. Past performance is not necessarily indicative of future returns. The following indexes were used as proxies in the performance tables: Global Stocks = MSCI ACWI; U.S. Large Cap = S&P 500; U.S. Large Value = Russell 1000 Value; U.S. Large Growth = Russell 1000 Growth; U.S. Small Cap = Russell 2000; Int’l Dev Stocks = MSCI EAFE; Emerging Markets = MSCI EM; U.S. Inv Grade Bonds = Barclays U.S. Aggregate; U.S. High Yield Bonds = Barclays Corporate High Yield; Emerging Markets Debt = JPMorgan EMBI Global Diversified; Int’l Bonds = Barclays Global Treasury ex US; Cash = 3month T-Bill; Sector returns displayed in the chart represent S&P 500 sectors, while treasury benchmarks are from Barclays.