 Mutual Fund Age and Morningstar RatingsMatthew R. Morey Financial Analysts Journal, 2002, vol. 58, issue 2, 56-63 Abstract: The study reported here identified an age bias in the Morningstar mutual fund ratings. I found that the average overall star ratings of seasoned funds are consistently—and in many cases, significantly—higher than the average overall star ratings of younger funds. This bias is not the result of a survivorship bias but of the methodology Morningstar uses to calculate the ratings. If star ratings affect fund flows, then this age bias in the Morningstar ratings is of significance to the mutual fund industry and to investors. With the tremendous growth of privately managed retirement accounts and the more than 10,000 mutual funds now available to investors, mutual fund ratings have never been more in demand. One popular, if not the most popular, provider of mutual fund ratings today is Morningstar, Inc. Started in the mid-1980s, Morningstar has grown largely as a result of the success of its five-star rating system. Similar to the rating of hotels, movies, and restaurants, Morningstar rates mutual funds on a scale of one to five stars, where one star is the worst rating and five stars is the best.The Morningstar rating system has become so popular that many people believe investment flows in and out of mutual funds are closely related to the Morningstar ratings. Moreover, the heavy use of Morningstar ratings in mutual fund advertising suggests that mutual fund firms believe investors care about Morningstar ratings.The purpose of the study reported in this article was to document a methodological bias in the Morningstar ratings. The bias results from the way Morningstar treats funds of different “ages.” Morningstar ratings are created by aggregating 3-year, 5-year, and 10-year star ratings for each fund. The ratings of young funds that do not have 5 years of return history are based solely on the 3-year ratings. The ratings for funds with 10 years or more of return history are based on a 20 percent weighting of the 3-year rating, a 30 percent weighting of the 5-year rating, and a 50 percent weighting of the 10-year rating. Therefore, the ratings of older funds are less likely to fall than those of younger funds. The result is that older funds tend to have higher ratings—not because of performance per se but because of the weighting system.After illustrating this bias, I document that the bias emerges in the actual ratings. Upon examining each of the 37 quarterly Morningstar data disks from October 1991 to October 2000, I found that the average overall star rating of the seasoned (oldest) funds was greater than that of the young funds in 36 of the 37 quarters. Moreover, in 26 of 37 cases, the seasoned funds' average rating was significantly higher. Finally, I found in robustness checks that these results are related to methodological bias, not survivorship bias.Two implications of the results are particularly important. First, if investors do care about the ratings, then these results mean that investors should be careful in interpreting the overall ratings as signals of past performance, much less future performance. Investors need to look beyond the ratings when deciding which fund(s) to invest in. And to its credit, Morningstar gives similar advice.Second, mutual fund rating services may want to use a single consistent time horizon to evaluate funds. Systems that use time horizons that depend on the age of the fund can lead to biases that make the ratings more subjective than objective. Again, to its credit, Morningstar has tried to address this issue by putting more emphasis on alternative ratings that use the same amount of information for each fund. Date: 2002 Downloads: (external link) Related works: Export reference: BibTeX RIS (EndNote, ProCite, RefMan) HTML/Text Persistent link: https://EconPapers.repec.org/RePEc:taf:ufajxx:v:58:y:2002:i:2:p:56-63 Ordering information: This journal article can be ordered from Access Statistics for this article Financial Analysts Journal is currently edited by Maryann Dupes More articles in Financial Analysts Journal from Taylor & Francis Journals |
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