If you take what people say at face value, you'd think there's not an advisor in the world who would care that Morningstar is shaking up the way it star rates mutual funds.
How many advisors, after all, would really admit to paying attention to star ratings?
Virtually any advisor you talk to says the Morningstar rating system is too simplistic, often misleading and too oriented to the fad investment style of the day. A one- to five-star rating system may be good for movies, advisors will say, but it's not something that should be used to judge mutual funds.
Yet advisors also agree on something else: Clients typically do care about star ratings. One might even say the ratings represent a Sword of Damocles in the lives of advisors-hanging over their every fund recommendation, whether they agree with the system or not.
"They play into the minds of clients a lot," says John Brown, president of Brown Financial Advisory in Fairhope, Ala. "They really like to see a high Morningstar rating. When I suggest a change, particularly with a new client, they like to see those stars."
Which is why the change in the Morningstar rating system is something advisors really do care about. The changes, in fact, are partly driven by complaints advisors have long had about the way Morningstar doles out its stars.
The way Morningstar has been rating mutual funds since 1985 is by taking all mutual funds and dividing them up into four categories: U.S. stock funds, international stock funds, taxable bond funds and municipal bond funds. The funds within each category are then rated, on a risk-adjusted basis, according to their three-, five- and 10-year performance records. (A mutual fund needs a minimum three-year history to get rated).
Funds then are given one to five stars, with five being the best, according to a bell curve. The top 10% get five stars, the next 22.5% get four stars, the next 32% get three stars, etc.
The system initially worked because it was born at a time when mutual funds typically were large, beefy investment vehicles that held a broad array of stocks. Mutual funds were less specialized back then, so comparing them across four broad categories was not a big problem. Now, 17 years later, the landscape is quite different.
Mutual funds have discovered more niches-a trend that is accelerating as funds now are viewed as building blocks of a diversified portfolio. That means the rating system has been clumping funds of differing styles-small-cap value, large-cap growth, real estate, etc.-into one group and rating them on the same bell curve.
The result, advisors say, has been an apples-to-oranges rating system that doles out high ratings to whatever investment style happens to be in vogue at the time. Quality funds in an out-of-fashion sector, meanwhile, get unfairly penalized by this methodology. "In 1999, you could not find one value fund with a five-star rating," says Michael D. Kresh of M.D. Kresh Financial Services in Hauppauge, N.Y.
Now, he notes, there's a plentiful number of value funds with five stars, and growth funds have been pushed down to the lower rungs of the ratings ladder. "It's grossly misleading to clients in terms of whether a fund is a bad or good fund," Kresh says.
In fact, he and other advisors have long felt the system not only rates the mutual fund market, but partly drives it. "Over the last couple of years, all of the net inflows have been into four and five-star funds, and all the outflows from the one and two-star funds," he says.
Brown, meanwhile, says he braces for a reaction from clients whenever he recommends a fund with a rating of one or two stars. "In fact, I'll raise the issue upfront because I know it's coming," he says.
In what advisors say is a move that's long overdue, Morningstar finally acknowledged the problem and announced that a new system will be put in place as of July. Under the new system, the 15,000 mutual funds in Morningstar's database will be divided among 48 categories instead of four. Ratings also will place more emphasis on month-to-month fluctuations in a fund's performance and downward risk.
Ratings will still be doled out according to a bell curve. But with so many more categories, it is hoped the new system will be more resistant to trendiness, says Don Phillips, Morningstar's managing director.
Along the same lines, Morningstar also has announced it will enhance its "style box" system to more accurately reflect how funds invest. "We're trying to make it easier for an investor to recognize and act upon buying a quality fund that happens to be in an out-of-favor sector of the market," Phillips says.
When the rating changes kick in, investors will see a considerable number of changes, he notes. The imbalances caused by current trends, he says, will start to even out. Expect some value funds to lose a star or two, for example, and for some growth funds to gain some stars. The same with small cap versus large cap, he says.
Bond ratings also will be more finely tuned. Formerly, all bonds were thrown into the same hopper, Phillips says, but the new system will have separate categories for short-term, intermediate and long-term issues.
Advisors appear to be welcoming the changes-while still expressing some exasperation with the star system in general. Some even say they may be able to make some use of the ratings system themselves.
"It's likely to make life a bit easier," says Harold Evensky, principal of Evensky, Brown & Katz in Coral Gables, Fla. Although Evensky says he has for the most part ignored Morningstar ratings, the narrower focus of the system could help raise red flags on some funds.
"Under the new ratings, if they give something a one- or two-star rating, maybe they will be flagging something I missed," he says. "If they define the categories in a way I find meaningful, I wouldn't use their ratings as a reason to pick a fund, but a reason to question why I pick something."
That would be a welcome change, Evensky says, because historically Morningstar's system has been woeful in its treatment of specialized fund sectors. "In the past, emerging-markets funds all got two stars or less-good, bad or indifferent," he says.
Kresh also has had his share of bad experiences. He cites the treatment Morningstar has given the Merger Fund, a merger and acquisition arbitrage fund that is popular among advisors looking for a portfolio diversifier that doesn't carry an undo amount of risk and has a low correlation to the stock market.
Despite having a glowing record and never suffering a loss in its history, the fund endured a three-star rating because it was overshadowed by large-cap growth, Kresh says. He continued to use the fund, but with the rating, "it was extremely difficult to explain to clients."
Kresh is still concerned that clients will over rely on the star ratings by trying to build a "Five-Star" portfolio. "My concern is if consumers are still shopping only for five-star funds, they will still end up with a very inappropriate portfolio that's a collection of poorly matched Morningstar five-star funds," he says.
Phillips says Morningstar is well aware of the complaints advisors have of the star system, and he adds that the company always has noted the ratings are just one of many indicators investors should look at in selecting a fund.
Even though some investors may misuse the ratings, they still have value, he says. "What's the alternative?" he asks. "If they didn't have this shortcut, what shortcut would they use? To select from a universe of 15,000 funds, you have to take some shortcuts."
Advisors, meanwhile, acknowledge that it's better to learn to live with the ratings because they're not disappearing any time soon. On the contrary, the scope of Morningstar's influence is likely to increase. The company is going to start releasing data on separate accounts and is considering getting involved in the alternate investments and hedge fund markets.
Besides, Brown says, it's not exactly a bad thing for advisors to have to explain to clients why they're recommending funds with low Morningstar ratings. Sometimes, an advisor can cite reasons that go well beyond a simplistic star rating, such as a change of manager, investment-company ownership or the fund's investment charter. "I think it really helps our credibility," he says.