Overcoming the
Morningstar Heuristic
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...
2 | Overcoming the Morningstar Heuristic
The Morningstar star rating was introduced in 1985 and “among other things, is de...
3 | Overcoming the Morningstar Heuristic
period from 1998 to 2007, only 42.50% were able to outperform the S&P 500 during ...
4 | Overcoming the Morningstar Heuristic
to future returns, the coefficient was negative, implying that, on average, an in...
5 | Overcoming the Morningstar Heuristic
Despitetheevidencepresentedaboveandincreasedattentiontothelackofpredictivepowerof...
6 | Overcoming the Morningstar Heuristic
rating just to the right of the name of the fund. Reading left to right, the star...
1
Compiled from Morningstar data
2
Diane Del Guercio and Paula A.Tkac, Star Power:The Effect of Morningstar Ratings on Mut...
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Whitepapper morningstar heuristic_rev 2 revlrf

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Are Morningstar stars predictive? No.

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Whitepapper morningstar heuristic_rev 2 revlrf

  1. 1. Overcoming the Morningstar Heuristic Addressing Investor’s Star Rating Anchoring Bias
  2. 2. 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. $250,000 $200,000 $150,000 $100,000 $50,000 $0 -$50,000 -$100,000 -$150,000 1-star 2-star 3-star 4-star 5-star Estimated Net Flow 2008 Estimated Net Flow 2009 Estimated Net Flow 2010 Estimated Net Flow 2011 Estimated Net Flow 2012 Exhibit 1 Estimated Asset Flows 2008-2012 ($ millions)
  3. 3. 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 perspective6 , 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
  4. 4. 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 Overall Rating. 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 Exhibit 2 Distribution of Annualized Returns 2008-2012 15% 10% 5% 0% -5% -10% Number of Funds (Sorted by 1998-2007 Overall Rank) 3-star fund 5-star fund 2-star fund 4-star fund 1-star fund AnnualizedReturn2008-2012 100 200 300 400 500 6000
  5. 5. 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 Rating Year of Annual Return 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 Exhibit 3 Regression Results 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.
  6. 6. 5 | Overcoming the Morningstar Heuristic DespitetheevidencepresentedaboveandincreasedattentiontothelackofpredictivepowerofMorningstar’s star rating7 , 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
  7. 7. 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.
  8. 8. 1 Compiled from Morningstar data 2 Diane Del Guercio and Paula A.Tkac, Star Power:The Effect of Morningstar Ratings on Mutual Fund Flows, Working paper 2001-05,August 2001. 3 Morningstar RatingTM Methodology Paper, June 30, 2009 4 Morningstar RatingTM Methodology Paper, June 30, 2009 5 The Associated Press, Morningstar’s Analyst Ratings, at a Glance, June, 21, 2012. 6 Robert D. Hershey, Jr. Fund Ratings that Take Aim at the Future, January 7, 2012. 7 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. 8 https://www.investmentplan.com/morningstar-star-ratings/; http://www.thinkadvisor.com/2010/08/01/ morningstar-investment-conference-highlights?ref=desktoplink 9 Daniel Kahneman won the 2002 Nobel Memorial Prize in Economic Sciences for his study of economic decision making and judgment. 10 Daniel Kahneman and AmosTversky, OnThe Psychology of Prediction, July 1973, Psychological Review. 11 Sam Mamudi, Investors Caught with Stars in their Eyes (Wall Street Journal), 06-01-10 12 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)

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