Why Index Funds Only Receive Three Stars from Morningstar

I've written before on the predictive value of Morningstar's star-rating system, as the evidence has shown that the stars have little to no value when projecting future performance. This topic was one of two addressed by the Vanguard Institute's paper, "Mutual Fund Ratings and Future Performance." The other issue is one we haven't discussed yet and is a question I frequently get: "If index funds are so good, why do many of them carry three-star (average) ratings?"

The authors explain that the "the natural distribution of the actively managed fund universe around a benchmark [the index] dictates that an appropriately constructed and managed index fund should fall somewhere near the center of that distribution." (It's important to note that it will fall to the right of the center of distribution due to lower costs.) And because Morningstar weights three-year performance more heavily than five- or 10-year performance, the time frame is short enough to randomly allow active management decisions to outweigh the cost disadvantages.

Think of it this way: a sprinter in a 100-yard dash might be able to overcome the disadvantage of wearing a two-pound weight on each ankle, but the odds of doing so decrease with the length of the race. And the odds of winning a marathon with that handicap are close to zero. Thus, it's over longer periods that cost advantages of passively managed funds have a greater influence on the distribution of relative performance.

Do Star Ratings Predict Performance? To answer this question, the authors examined the excess returns over the three-year period following a given rating. They chose the three-year period because Morningstar requires at least three years of performance data to generate a rating and investment committees typically use a three-year window to evaluate the performance of their portfolio managers. The period covered was June 30, 1992 through August 31, 2009. The following is a summary of their findings:

• 39 percent of funds with five-star ratings outperformed their style benchmarks for the 36 months following the rating, while 46 percent of one-star funds did so.
• All the star-rating groups produced negative excess returns in the succeeding three years. Even worse, the four- and five-star figures were more negative than those of lower-rated groups.

The authors concluded: "Higher ratings in no way ensured that an investor would increase his or her odds of outperforming a style benchmark in subsequent years." In fact, they found that "5-star funds showed the lowest probability of maintaining their rating, further confirming that sustainable outperformance is difficult. This means that investors who focus on investing only in highly rated funds may find themselves continuously buying and selling funds as ratings change. Such turnover could lead to higher costs and lower returns as investors are continuously chasing yesterday's winner."

This study adds to the already impressive body of evidence that demonstrates that the higher costs of active management have a strong tendency to lead to lower investment returns.