Addressing Investor’s Star Rating Anchoring Bias
1 | Overcoming the Morningstar Heuristic
Investors have a strong preference for investing in mutual funds rated four stars and five stars by Morningstar,
as demonstrated by analyzing fund estimated net asset flows. Exhibit 1 displays the estimated net asset flows
from 2008 to 2012 of funds assigned a Morningstar Overall Rating. In addition, 85.90% of all estimated
net asset flows into rated United States mutual funds over that same time period were invested into four-
and five-star rated funds across all US category groups. The estimated net asset flows during 2008 further
demonstrate this preference for highly rated funds. During 2008, estimated net asset inflows of five-star
rated mutual funds reached $11.52B while all mutual funds with a star rating less than five saw a cumulative
estimated net asset outflow of $122.72B1
. A working paper by the Federal Reserve Bank of Atlanta also
notes a statistically significant positive relationship between increases in star ratings and increases in asset
flows into those rated funds, with changes in asset flows occurring immediately after a change in star rating2
The analysis of asset flows above clearly demonstrates evidence for investor’s preference for highly rated
funds but do the star ratings have any predictive power with respect to future fund performance?
“The fault, dear Brutus, is not in our stars, but in ourselves...”
— William Shakespeare, Julius Caesar
Past performance does not guarantee future results.
Data Source: Morningstar Direct. Estimated Net Asset flows plotted by star rated mutual fund. Non-rated funds are omitted.
1-star 2-star 3-star 4-star 5-star
2 | Overcoming the Morningstar Heuristic
The Morningstar star rating was introduced in 1985 and “among other things, is designed to convey a
sense of how skillfully a fund has been managed3
.” The Morningstar star rating accomplishes this by rank-
ordering risk-adjusted mutual fund past performance within a category peer group, then — assuming a
normal distribution of risk-adjusted performance — awards five stars to funds in the top 10% of risk-
adjusted performance, four stars to funds in the next 22.5%, three stars to funds in the next 35%, two
stars to funds in the next 22.5%, and one star to funds in the bottom 10% of risk-adjusted performance.
The Morningstar star ratings are calculated over three-, five- and ten-year periods, with the Overall Rating
calculated as the weighted average of the number of stars received by a fund over the three-, five- and ten-
year periods. The weighted average Overall Rating is calculated according to the table below4
Months of Total Return Overall Rating
36-59 100% three-year rating
60-119 60% five-year rating
40% three-year rating
120+ 50% 10-year rating
30% five-year rating
20% three-year rating
Morningstar star ratings may fluctuate, however, due to a variety of factors, including: i) rounding the
rating to the nearest integer, ii) reaching a three-, five-, or 10-year milestone; iii) style drift; iv) inclusion
into a specific peer group.
Because of the star rating’s focus on past performance, Morningstar introduced the new Analyst Rating
system in November 2011 which evaluates funds based on People, Process, Parent, Performance and Price,
and awards ratings of Gold, Silver, Bronze, Neutral and Negative. This new rating system is intended
to supplement the star rating by analyzing a fund’s qualitative features to determine and communicate
Morningstar’s opinion of a fund’s future prospects5
. While the intent is to provide a more forward-looking
, there is not enough data at this point to determine its effectiveness so the Overall Rating is the
focus of my analysis here.
A review of a sample of 560 equity mutual funds — all incepted prior to 1998 and domiciled and traded
in the United States from 1998 to 2012 — indicate that the Morningstar Overall Rating is not a good
indicator of future performance. Of the 80 mutual funds with five-star Overall Ratings during the 10-year
3 | Overcoming the Morningstar Heuristic
period from 1998 to 2007, only 42.50% were able to outperform the S&P 500 during the following five-
year time period starting in 2008 on an annualized basis. Five-star funds during those same time periods
experienced an Overall Rating average decline of 1.94 stars, with only seven funds retaining that five-star
rating during the next five-year period. This contrasts with the performance of one-star funds: 52.94% of
one-star funds over the 10-year period starting in 1998 outperformed the S&P 500 during the five-year
time period starting in 2008 on an annualized basis, with an average overall rating increase of 1.82 stars.
Exhibit 2 shows the distribution of annualized returns from 2008-2012 on funds grouped by Overall
Rating from 1998 to 2007; the scatter plot clearly illustrates the lack of predictive power exhibited by the
Past performance does not guarantee future results.
Data Souce: Morningstar Direct.All rated mutual funds were sorted by star rating and their annualized returns were plotted.
Further examination of the Morningstar Overall Rating sheds more light on its inability to accurately
forecast future performance. Regression analysis was used to determine if a statistically significant
relationship existed between the Overall Rating in one year, the returns experienced by a fund over each of
the next three years and the annualized three-year return. The analysis was conducted from 2003 to 2009
using the Morningstar overall rating as the independent variable, and using the fund’s return in each of the
successive three years and the annualized three-year return as the dependent variable. The t-stats, p-values
and regression coefficients are provided on Exhibit 3 with the statistically significant results highlighted
(assuming a 95% confidence interval). The regression analyses showed statistically significant results in
only six instances out of 28. In those years where the rating showed a statistically significant relationship
Number of Funds (Sorted by 1998-2007 Overall Rank)
100 200 300 400 500 6000
4 | Overcoming the Morningstar Heuristic
to future returns, the coefficient was negative, implying that, on average, an increase in the star rating
resulted in a decrease in future returns. The occurrence of a statistically significant relationship between
star ratings and future fund performance over each of the next three years was very sporadic and did not
show a positive relationship between the fund’s rating and its future performance. When conducted across
all time periods, the regression analysis showed no statistically significant relationship between the Overall
Rating and returns in each of the succeeding three years or the succeeding three-year annualized return.
Year of Overall
Year of Annual
Coefficient T – Stat P-Value
2003 2004 0.00325127 1.6365 0.1021
2003 2005 0.0005246 0.3269 0.7438
2003 2006 2.689E-05 0.0139 0.9889
2003 3Yr.Annlzd. 04-06 0.00126162 1.0335 0.3017
2004 2005 0.00096469 0.5809 0.5615
2004 2006 0.00085651 0.4275 0.6691
2004 2007 -0.0055969 -1.6434 0.1007
2004 3Yr.Annlzd. 05-07 -0.0012282 -0.8915 0.3729
2005 2006 0.00267001 1.3400 0.1806
2005 2007 -0.0097666 -2.8907 0.0039
2005 2008 0.00199272 0.8611 0.3894
2005 3Yr.Annlzd. 06-08 -0.0009475 -0.7290 0.4662
2006 2007 0.00396874 1.1562 0.2480
2006 2008 -0.0045077 -1.9294 0.0540
2006 2009 -0.0060605 -1.5259 0.1274
2006 3Yr.Annlzd. 07-09 -0.0027068 -2.0869 0.0372
2007 2008 -0.0078878 -3.1781 0.0015
2007 2009 0.00808239 1.9095 0.0566
2007 2010 0.0031355 1.1746 0.2405
2007 3Yr.Annlzd. 08-10 -0.001253 -0.8319 0.4057
2008 2009 -0.0101607 -2.5091 0.0123
2008 2010 -0.0023164 -0.9052 0.3656
2008 2011 -0.0042827 -2.2984 0.0218
2008 3Yr.Annlzd. 09-11 -0.005058 -3.2556 0.0012
2009 2010 -0.0022105 -0.8283 0.4077
2009 2011 0.0017611 0.9039 0.3663
2009 2012 -0.0014224 -0.9447 0.3451
2009 3Yr.Annlzd. 10-12 -0.0004352 -0.4000 0.6893
Overall Ratingt Returnt+1 0.0019326 0.6438 0.5197
Overall Ratingt Returnt+2 0.0018936 0.6278 0.5301
Overall Ratingt Returnt+3 -0.0035034 -1.1511 0.2497
Overall Ratingt Returnann. 0.0009962 0.7742 0.4388
Past performance does not guarantee future results.
Data Source: Morningstar Direct. Overall Ratings for mutual funds were regressed against their annual return one, two and
three years after the Overall Rating was issued as well as the annualized return for the three years following the year the
Overall Rating was issued. For all time periods, the Overall Rating at time t was regressed against annual return at t+1, t+2,
and t+3 years after the Overall Rating was issued as well as the annualized return for the three years following the year the
Overall Rating was issued.
5 | Overcoming the Morningstar Heuristic
, why does the rating continue to have such influence over investor decisions? Even Don
Phillips acknowledged at a conference in 2010 that, “the star rating is a grade on past performance. It’s an
achievement test, not an aptitude test…We never claim that they predict the future.8
” The undue influence
the rating has on investor decision-making may be explained by psychological biases resulting from the
tendency of people to use common sense, educated guesses or shortcuts (i.e. heuristics) to make decisions
in the face of uncertain outcomes. Kahneman9
and Tversky (1973) note that, “in making predictions and
judgments under uncertainty, people… rely on a limited number of heuristics which yield reasonable
judgment and sometimes lead to severe and systemic errors.10
” Making investment decisions is difficult,
and this is especially true if an investor has limited investing experience or expertise. Due to the uncertain
nature of future investment decision outcomes, investors seek out heuristics to guide them when making
these decisions. This is where the Morningstar star rating comes in. Although Phillips acknowledged the
rating’s focus on past performance, three weeks prior to that acknowledgment the Wall Street Journal
reported that [Don] Phillips “believes [the star ratings] are as good a shortcut as people have when it comes
to picking funds.11
” The evidence presented above, however, demonstrates that the ratings do not show a
consistent ability to predict or forecast funds’ future performance, and relying on the star rating may lead to
poor investment decisions.
That the Morningstar star rating acts as a heuristic doesn’t fully explain the rating’s popularity with
investors when making decisions. The key to understanding the rating’s popularity may be found with
the biases which can be formed when using a heuristic. Kahneman and Tversky (1974) demonstrate that
“anchoring” may lead individuals to make poor estimates and affect their decision-making. “Anchoring”
occurs when people allow an initial value to bias their estimates of other values, with estimates adjusted
from the initial value. Kahneman andTversky demonstrate this effect by asking subjects to estimate various
values, such as the number of African countries represented in the United Nations, after spinning a wheel
of fortune numbered 0-100. Kahneman and Tversky found that the arbitrary numbers obtained from
spinning the wheel of fortune influenced the subjects’ guesses of the values they were asked to estimate.
The Morningstar star rating may serve the same purpose as the wheel of fortune; it acts as a statistically
insignificant anchor which can bias investment decisions. Unfortunately, this phenomenon may make
it difficult to recommend funds that do not carry a high Morningstar star rating if investors allow the
anchoring bias to affect their investment decisions.
Morningstar exacerbates the anchoring bias through the placement of the Morningstar star rating on
its reports and through the use of heavy advertising12
. A review of reports distributed by Morningstar
demonstrate their use of the star rating. The Investment Detail and QuickTake reports provide the star
6 | Overcoming the Morningstar Heuristic
rating just to the right of the name of the fund. Reading left to right, the star rating is the second piece
of information received about the fund, after its name. In the Fund vs. Fund and Investment Summary
reports, the Morningstar star rating is placed in the upper third of the page, near the other performance
metrics. Morningstar even has an entire report focused on a fund’s Morningstar star rating history. The
placement and use of these ratings make it easy for investors to use the rating as a heuristic to make
investment decisions and to formulate an anchoring bias.
Investing is complex and uncertain. This can cause investors to seek out intuitive ways of making sense
of investment decisions but can lead them toward making poor investment choices. While it is intuitive
to think that a higher-rated fund would perform better than a lower-rated fund in the future, the
evidence presented doesn’t support that. Past performance is not indicative of future performance and the
Morningstar overall rating illustrates this well. Picking funds on the basis of the star rating is akin to picking
lottery numbers based on last week’s drawing. The use of the Morningstar star rating as a heuristic can be
especially problematic due to its prevalence and positioning in many of Morningstar’s reports. The rating
is oftentimes one of the first pieces of information received about a fund which allows investors to use the
rating as a heuristic and to formulate a Morningstar star rating anchoring bias which can adversely affect
their investment decisions. By understanding that the star rating may serve as an anchor for investors, and
bias their decision-making, we may be able to improve investment decisions.
Compiled from Morningstar data
Diane Del Guercio and Paula A.Tkac, Star Power:The Effect of Morningstar Ratings on Mutual Fund Flows,
Working paper 2001-05,August 2001.
Methodology Paper, June 30, 2009
Methodology Paper, June 30, 2009
The Associated Press, Morningstar’s Analyst Ratings, at a Glance, June, 21, 2012.
Robert D. Hershey, Jr. Fund Ratings that Take Aim at the Future, January 7, 2012.
Don Philips, Star Wars, the Sequel (Morningstar Advisor), 08-12-10; Sam Mamudi, Investors Caught with Stars in
their Eyes (Wall Street Journal), 06-01-10; Michael Maiello, Ignore Morningstar’s Stars, (Forbes), 1-30-09.
Daniel Kahneman won the 2002 Nobel Memorial Prize in Economic Sciences for his study of economic
decision making and judgment.
Daniel Kahneman and AmosTversky, OnThe Psychology of Prediction, July 1973, Psychological Review.
Sam Mamudi, Investors Caught with Stars in their Eyes (Wall Street Journal), 06-01-10
Michael Maiello, Ignore Morningstar’s Stars, (Forbes), 1-30-09.
Reviewed by Larry R Frank Sr., Better Financial Education, Registered Investment Adviser (California)
LWI Financial Inc. (“Loring Ward”) is an investment adviser registered with the Securities and Exchange Commission.
Securities transactions are offered through its affiliate, Loring Ward Securities Inc., member FINRA/SIPC. IRN R 13-276 (Exp 8/15)