Disclaimer: I have no financial ties to Morningstar nor do we pay for their research or any of their services as a firm. I spoke at their conference this past spring, for free. I have no ties to the Wall Street Journal other than my paid subscriptions to WSJ and Barron’s.
This is a tough one for me. I greatly respect the reporters who did the Wall Street Journal takedown of Morningstar today – Kirsten Grind in particular is must read for our corner of the financial industry. I also think they did a really nice job with the charts and graphics, and also in framing the issues.
It is absolutely true that star rankings for funds have been misunderstood forever. It’s also probably true that professionals who definitely know better are using them anyway, because they make a fund easy to sell to clients. A high star ranking is also a great tool for ass-covering, in the event a fund blows up. “Don’t point your finger at me, it was Morningstar!”
But just because star rankings are not predictive, does that mean Morningstar is doing a disservice by providing them? I don’t think so. There are thousands and thousands of funds and they need to be categorized somehow. Professionals who don’t understand the concept of mean reversion – or who cannot comprehend the idea that an outperforming fund is just as hard to select in advance as an outperforming stock – have no business even being in the industry. Morningstar didn’t make them uninformed, they already were.
I won’t comment on all of the concerns raised, some of which are valid and important, but I do want to say the following before I send you over:
- Morningstar is a fantastic organization that has done a good job at shedding light on an industry that often cloaks itself in opacity.
- On balance, investors of all classes are better off to have the information they put out into the world. The problems come in when this information is used incorrectly, in my judgment.
- Morningstar has not shied away from tearing its own ranking systems down over the years. A 2010 piece by strategist Russell Kinnel has become legendary in the business owing to its honesty – Kinnel essentially found that the one factor most predictive of a fund’s success is how much it costs. He updated this last year, fearlessly and regardless of how contradictory it was in the context of a ratings system that looked at other factors. Gotta respect that.
- I’m embarrassed for professionals who think past performance – which is how the star system works – assures some semblance of future performance. It literally says the opposite on every piece of fund literature ever produced in the last 30 years.
- We have a slide in our investor presentation that demonstrates how impossible it is for anyone to predict which funds will even exist ten years from now, let alone which will have outperformance versus a benchmark. You have greater odds of discovering the next Rhianna among kids singing in the subway. This insight is not a secret.
- The financial advisors mentioned in the article need to start reading more financial blogs, where the impossibility of selecting outperforming managers in advance has been one of our staple tropes over the last ten years. What the hell are these people reading every day? Get with the program.
Okay, I’ll send you over now.