mutual fund ratings: do they really matter? philip s. russel philadelphia university, usa 2006 pbfea...

MUTUAL FUND RATINGS:DO THEY REALLY MATTER?

Philip S. RusselPhiladelphia University, USA

2006 PBFEA Conference, Taipei, Taiwan

Research Funded by: Lindback Foundation

Agenda

1. Introduction 2. Motivation 3. Research Questions 4. Morning Star Rating Methodology 5. Data 6. Discussion of Results 7. Conclusion

Introduction Mutual Fund Industry

Exponential growth from a mere $50 b5llion in 1974 to nearly $9,000 billion in 2004.

In USA, the number of mutual funds exceed the number of stocks listed on organized exchange, making the selection of mutual funds an onerous task for average investor.

Role of Rating Agencies

How can investors screen thousands of funds? One option is to rely on some kind of

rating services Ratings provide a composite

measure of mutual fund performance Currently being provided by Lipper,

Value Line and Morningstar. Morning star is the most prominent.

2. Motivation

Ratings and Fund Flow While Morningstar does not claim to forecast

performance, anecdotal and empirical evidence suggests that investors are increasingly relying on mutual fund ratings to make their investment decisions. 97 percent of the money invested in no-load

equity funds flowed into funds with four or five star rating (Wall Street Journal, 1996)

5 Star funds claim 50.5% of all assets of domestic equity funds (Keenan, 2002)

Based on 3,500 funds and 12,000 rating changes, Guercio and Tkac (2002) report causal relationship between rating and fund flow.

Thus predictive ability of morning star rating system is an important question as ratings have become extremely popular and seem to significantly influence the allocation of investment dollars.

3. Research Questions

Research Questions1. Performance: Does picking 5-star funds

lead to superior performance? 2. Persistence: How persistent are the

ratings? Does the degree of reliability vary among the groups? That is, is a 5-star rating more reliable than a 3-star rating in forecasting future performance?

3. Star Attributes: Are there any distinctive differences among funds, based on their rating category?

4. Age Bias: Is there an age bias in rating?

4. Morning Star Rating Methodology

Morning Star Rating Methodology Mutual funds are classified into 48 investment groups.

Until 2002, there were only 4 groups - domestic equity, international equity, taxable bond, and municipal bond

Ratings recognizes the performance within each group based on historical risk and return measures.

Based on monthly data, ratings assigned for 3,5,10 years and also “overall rating” based on weighted average of 3,5,10 year ratings.

The Stars

Rank StarsTop 10% 5Next 22.5% 4

Middle 35% 3Next 22.5% 2Bottom 10% 1

Biases in Rating Load versus No-load

Rating biased in favor of no-load funds Morey (2002) reports that out of 164 funds

receiving 5-stars, 75% were no-load funds Age of Fund

Rating favors new funds due to surviorship effect (Blume, 1998)

Rating favors seasoned funds due to weighting system (Morey, 2002)

Seasoned funds regress towards the mean due to interaction between age of fund and fund size (Adkisson and Fraser, 2003)

5. Data

Data Source: Morningstar Principia Morning star changed the rating

methodology in July 2002 Current study based on quarterly data for

2003 for growth funds.

Quarter Number of Funds

I 1811II 1915III 1996IV 2074

6. Discussion of Results

6.1 What are the attributes of Winning Funds?

Reference: Table 4

5-star groups are clearly “winning funds”

Star 5-year Ret%

15 yearRet%

Beta

1-Star -4.85% .81 1.21

5-Star 7.12 2.05 0.88

All funds

.60 1.77 0.95

Attributes of Star Categories

Attribute 1-Star 5-Star

Alpha -11.38 1.56

Turnover 159.04 99.15

Tenure 3.73 6.04

Expense Ratio

2.03 1.46

Asset Size 171.88 982.93

6.2 Is There an Age Bias in Rating? We first divide the sample for each

quarter into three groups: Large Cap, Medium Cap and Small Cap

We further divide the sample based on their age, in years: Seasoned funds (age ≥ 10 years), Middle-aged funds (5 ≤ age < 10), and young funds (5 > age ≥ 3)

We then test for differences in overall rating between Seasoned Versus Young funds, Seasoned versus Middle age funds, and Middle age versus Young funds.

==> 9 times 4 = 36 inter-group comparisons

Of the 36 inter-group comparisons, only 7 are statistically significant.

Thus Morey’s (2002) contention that seasoned funds systematically receive higher overall rating is not observed.

6.3 Is there a Persistence in Rating?

Short-Term Persistence in Rating

Ratings for March compared with June/September/December ratings

Funds matched by name 1692 identical funds for March Versus June 1522 identical fund for March Versus September 1195 identical fund for March Versus December

Very few funds maintain their rating and persistence deteriorates. The following table shows March Versus December

Stars # of funds

3/30 Mean

12/30 mean

# same star

5 91 5 4.13 39

4 262 4 3.48 140

3 457 3 2.86 251

2 298 2 2.41 142

1 87 1 1.97 46

All 1195 2.97 2.92 618 (52%)

7. Preliminary Conclusion

Preliminary Conclusion Does Morning Star Rating Really Matter?

No. Investors are interested in future performance and

results show that very few funds maintain their “star rating”. Thus ratings should not matter!

The continued aggressive promotion of ratings in advertisements may indeed foster a “false” sense of confidence among naïve investors (who seem to ignore Morningstar disclaimer that stars do not reflect future performance)

Buyer Beware!

In progress: Expansion of results to bigger

database (2003, 2004, and 2005).

Refining the measurements of risk and return to assess performance.

Application of decision making/forecasting models.