The Morningstar Dilemma

The name Morningstar has become almost synonymous with the phrase Mutual Funds. For over 25 years, this company has provided investors with what has been generally accepted as meaningful, helpful, and accurate data, information that aids in making investment decisions. Its “star rating system” that grades mutual funds, has become the “gold standard” for identifying fund performance predicated on certain risk/reward factors –– until now, that is.

Morningstar, known initially as providing its clients with mutual fund ratings, has, over the past few years, acquired over a dozen other enterprises including Ibbotson Associates, the highly respected financial research and information firm, and SEC Edgar, the filing research company. As a result, since going public five years ago, the company has seen its share price escalate by about 30 percent. However, the major markets, including the very mutual funds covered by Morningstar, have at best broken even over that same period. Obviously, Morningstar’s company shares have done significantly better than its mutual fund recommendations. Still, Morningstar has developed a reputation that has enabled it to attract as subscribers almost 7.5 million individual investors, 245,000 financial advisors, and 4200 institutional clients. Its annual revenues total almost $500 million. It is obviously a major force in the financial services industry.

Morningstar has also prospered by reacting to, and exploiting the continuing permutations that occur on Wall Street. No longer merely a mutual fund advisor, Morningstar, in addition to actively managed mutual funds, now covers financial products including Index Funds, Exchange Traded Funds, Stocks, Hedge Funds, and even Options –– all that, in addition to evaluating some 350,000 individual offerings.

Facing a Dilemma

However, what does an organization of this magnitude do (one that enjoys a reputation for credibility and reliability), if in-house research uncovers an option available to its clients that degrades the most critical component of its information system, the one that has become almost its raison d'être –– the widely endorsed, and much publicized “star rating system”? The decision as to whether or not reveal the research results becomes a Hobson’s Choice –– if the information is divulged and publicized, sales could be adversely affected; if the research facts are suppressed and secreted, the results could ultimately be leaked, accompanied by a reputational nightmare.

Recently, Morningstar actually did find itself in that exact situation. A headline in The New York Times just two months ago, said it most succinctly: “Fund Expenses More Important Than 5-Star Status.” The article offered this explanation: “Educated investors know that past investment returns [the basis for the star-rating system] are not necessarily the best predictors of future results. [Instead] it’s mutual fund and other expenses [all charges paid by the investor] that really matter. Morningstar, in an act of radical and admirable transparency, recently [August 10 th, 2010] put that assertion to the test and found that expenses actually helped investors make better decisions than its own vaunted star-rating system.” The story continued: “In fact, using expense ratios as a guide to choose the best mutual funds were more helpful than star ratings 58 percent of the time.”

The Low Expense Advantage

Speaking out about this new Morningstar revelation, Russel Kinnel, director of mutual fund research at Morningstar, was quoted as saying: “Investors should make expense ratios a primary test in fund selection. They [expense ratios] are still the most dependable predictor of performance. [My underline]. Start by focusing on funds in the cheapest or two cheapest quintiles, and you’ll be on the path to success.” He also emphasized, that “In every asset class over every time period, the cheapest quintile produced higher returns than the most expensive quintile.” The research article also emphasized, “Perhaps the most compelling argument for expenses is that they worked every time –– because costs always are deducted from returns regardless of the market environment. The star rating, as a reflection of past risk-adjusted performance, is more time-period dependent.” (That last sentence is very similar to the advice that Will Rogers once gave: “Don't gamble; take all your savings and buy some good stock and hold it till it goes up, then sell it. If it don't go up, don't buy it.”)

A Skeptics View

Essentially, the Morningstar study found that although the star-system was still valuable, a low expense strategy was even more so. But as a skeptic, I have two questions. First, “With the almost unlimited resources at Morningstar’s disposal why did it take them 25 years to decide to test the validity of their star-rating system?” Second, the research commingled passively managed index mutual funds, (the fund category with the lowest expense factors) with the higher expensed actively managed funds. By doing so, this skewed the expense factors of all funds lower than they would have been otherwise, thus unfairly favoring the star system.

Why not conduct a study that makes a direct comparison between the star-rating system with only Index type funds (including Exchange Traded Funds) as a base? Is it because Morningstar recognizes that would be even more detrimental to the value of the star-ratings system? Oh yes, one other factor: What about taxes? All the Morningstar findings should be adjusted to “after tax” performance. That would even further depress the value of the star-rating system. (Exchange Traded Index Funds are particularly tax efficient, and this, coupled with their especially low expense ratios, should demand your consideration).

The Stars Begin to Fade

The following little known research paper published by the Vanguard Group just this past June raises even more penetrating questions about the star-rating system: “A common misconception among investors is that owning only highly rated funds (or avoiding poorly rated funds) will surely provide higher returns. However, Vanguard found the opposite when we analyzed Morningstar's mutual fund ratings and compared them against the rated funds' subsequent performance.

The recent Vanguard research paper Mutual Fund Ratings and Future Performance showed that, on average, just 39% of five-star funds outperformed their benchmark indexes in the three years following the initial rating, while 46% of one-star funds outperformed their benchmarks during the same period. In addition, the highest-rated funds were found to post the lowest average returns versus their respective benchmarks.” The study also concluded, “Vanguard's analysis showed that a year after the initial Morningstar rating, most funds had less than a 50% chance of earning the same rating again. And the probability was lowest for five-star funds.”

Happy Anniversary

The introduction of the Vanguard Group into the conversation reminded me that we are coming up on a singular anniversary, one that celebrates a momentous, inspiring, and seminal event that has changed the course of investing history –– on December 31, the S&P 500 Index Fund turns 35 years old.

Although Morningstar came into existence more than a quarter of a century ago, the original concept of index investing is even older. Some 40 years ago, Wells Fargo Bank pioneered the fundamental elements that led to the establishment of index investing, It constructed an equal weighted index of all the stocks on the New York Stock Exchange for the Samsonite Corporation pension fund.

The Wells Fargo effort, as well as a few others that attempted to establish index funds at the time, did not fare well. In fact, one of them was awarded the “Dubious Achievement Award from Pension & Investment magazine in 1972. However, despite these less than successful endeavors, the now legendary John Bogle, the then relatively new head of Vanguard, convinced his board of directors to establish the First Index Investment Trust (that ultimately was renamed the S&P 500 Index Fund).

Bogle’s Folly? Ha!

Unfortunately for Mr. Bogle, the concept was not well received, and in fact, initially that enterprise was dubbed as “Bogle’s Folly.” One of those questioning Mr. Bogle’s philosophy at the time was Forbes magazine. Talk about, “it’s never too late to make an apology.” Less than a month ago, the September 23 rd issue of Forbes, wrote as follows: “It's a bit late in coming but I'd like to officially retract a story Forbes published in May 1975. The piece, entitled ‘A Plague on Both Houses?’ pooh-poohed the creation of the Vanguard Group by John C. Bogle.” Now, 35 years later, admitting that was an egregious mistake, the Forbes article said this about Bogle: “[At] 81, [he] is retired from management but is as vociferous as ever an evangelist for cost-cutting. I think he has done more good for investors than any other financier of the past century” [my underline].

That at one time the S&P 500 Index Fund became the largest valued mutual fund is due primarily to John Bogle who, in 1999 was named one of the investment industry’s four "Giants of the 20th Century" by Fortune magazine. He was named one of the "world’s 100 most powerful and influential people" by Time magazine in 2004; in that same year he was awarded Institutional Investor's Lifetime Achievement Award.

If You’re Not Convinced By Now…

Jack Meyer, former president of the Harvard Endowment, was quoted as saying “The investment business is a giant scam. Investors should simply have index funds to keep their fees low and their taxes down.” David Swenson, chief investment officer of the Yale Endowment, provides the following advice, “Invest in low-turnover, passively managed index funds…” Even Warren Buffet, renowned value investor, recently bet $1 million that a simple S&P 500 index fund would outperform a collection of hedge funds over the next 10 years.