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An article in last week's Wall Street Journal, "Morningstar Mirage," caught our attention. Researchers at the Journal tested Morningstar's star rating system by examining the performance of thousands of funds dating back to 2003. Their results? Funds that earned high star ratings attracted the vast majority of investor dollars, and then most of them failed to perform.
Who is Morningstar?
As background, Morningstar is based in Chicago and has been providing data and research insights on a wide range of investment offerings, most notably, on mutual funds, since 1984. They also offer investment management services through their investment advisory subsidiaries. And today, their reach is pervasive. Nearly every asset manager in the world pays Morningstar for data services. Some 250,000 financial advisers rely on Morningstar's data, services or ratings, according to the firm. Morningstar's analysis and ratings influence investment decisions for a vast landscape of retirement plans and brokerage accounts.
The Findings
WSJ researchers found the rankings provided by Morningstar were often not predictive of the future and therefore relatively meaningless
to new investors. Of funds awarded their coveted five-star overall rating, they found only 12% did well enough over the next five years to earn a top rating for that period; 10% performed so poorly in the next five years that they received a rock-bottom, one-star rating.
The falloff in performance was most dramatic for domestic stock funds, the largest category of US funds by assets. For all of the measured periods (3, 5 and 10 years) five-star domestic equity funds were, on average, most likely to be one-star performers in the next five years.
Morningstar's response
On the day the article was published, Morningstar launched a PR campaign refuting the findings. They have said, "The star rating works well when it's used as intended: as a first-stage screen that helps identify lower-cost, lower-risk funds with good long-term performance. It is not meant to be used in isolation or as a predictive measure. Reversion to the mean is a powerful force that can affect any investment vehicle."
Morningstar's founder Joe Mansueto, has said the star rating system "is a way to whittle down a big universe into something more manageable." The firm said it has worked to make investors understand that star ratings should be just a starting point for their research.
What do we think?
First, we're not surprised by the WSJ findings. Our own research shows
that funds and money managers are unlikely to stay in the winner's circle for long, especially in highly efficient asset classes like large cap US equities. As the exhibit to the right shows, top tier US large cap equity managers inevitably experience significantly worse returns in the subsequent three-year periods.
For our clients, we take a passive approach to US equity investing. Whether you choose based on past performance, number of stars or something else, picking a long-term active manager who will continue to outperform is nearly impossible; and when you couple that fact with the fees charged by active managers, we believe taking a passive approach is the prudent course of action.
But what about non-US equity investments? Today we're all "trained" in the star system --- whether it's movie ratings, an Amazon product or restaurant reviews, stars represent a simple and fast way to assess value. But investing isn't so simple, especially when examining more complex opportunities like corporate or municipal bonds, hedge funds, master limited partnerships, private equity deals or real estate transactions. In each of those areas, due diligence performed by independent, highly-skilled and experienced analysts may be the difference between a positive and negative outcome.
That's why our clients benefit from our strategic partnership with Cliffwater LLC. Through the partnership we have access to:
- Investment insights from Cliffwater's deep and experienced staff
- Research on a wide variety of complementary (alternative) strategies
- Investment due diligence conducted by over 30 Cliffwater investment professionals
- Top-tier managers
- Innovative asset allocation modeling & oversight
So while we will continue to utilize Morningstar for the data and analytics tools we can't get anywhere else, we
--- and our clients
--- know better than to rely on their star system to pick investments.
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Last week the S&P 500 recorded its 7th weekly gain as equities surged higher on earnings news and positive economic data. The tech-heavy Nasdaq outperformed the other indexes thanks to better than expected earnings reports from Intel, Alphabet, Amazon and Microsoft.
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> GDP:
Though a rise of 2.5% was expected, last Friday the US Department of Commerce reported that Gross Domestic Product increased at a 3% annual rate in the July-September period after expanding at a 3.1% pace in the second quarter.
> Economic Expansion:
There has been much talk about the length of this bull market (8 1/2 years and counting), but the economy has been getting closer to record territory too. The economic expansion officially hit 100 months old this month and is now the third longest since WWII.
> The Federal Reserve:
The US Federal Open Market Committee (or FOMC) has decided to leave rates unchanged and maintain the Fed funds range at 1.0% to 1.25%.
No major changes were expected at the conclusion of their meeting today, but according to the CME Fed Watch Tool, there is over a 97% chance of a rate increase in December. Today's Fed statement is being overshadowed by speculation of who President Donald Trump will name tomorrow as his nominee for chair of the Fed board.
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On this day...
Back in 1941, celebrated American landscape photographer, Ansel Adams, shot one of his most famous photographs: "Moonrise, Hernandez, New Mexico."
Years later, Adams recounted the dramatic story of how this photograph came to be. As he was travelling along the highway, he happened upon a beautiful twilight scene. White clouds and snow-capped mountains on the far horizon reflecting the setting sun; in the foreground a cemetery with an assortment of gravestones also shining in the sinking rays; and, in the sky above, a gibbous moon on the rise. The story goes that he came to a screeching halt on the side of the road and scrambled to set up his tripod and 8 x 10 camera on top of his car. He described the situation as, "desperate: the low sun was trailing the edge of the clouds in the west, and shadow would soon dim the white crosses." But, he couldn't find his light meter, meaning that accurately photographing the scene would prove near impossible.
However, Adams was a technically gifted photographer and realized that the moon threw off approximately 250 c/ft2 of luminescence. Working with this figure, he calculated that a shot such as this would require a one-second exposure and an aperture setting of f/32. Unsure of this first shot, Adams readied himself for another exposure, yet, by the time he had reloaded the camera, the sun had sunk and the magic had drained away from the landscape.
Fortunately for all of us, Adams was able to capture the beauty of the landscape, despite the marginal conditions, in just one take.
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New Market Wealth Management offers modern investment solutions backed by extensive research and experience serving the needs of wealthy families. Through our strategic partnership with
Cliffwater LLC
, we have access to institutional-quality research, investment due diligence and asset allocation tools. We believe this level of experience and unique access to in-depth, sophisticated research are essential for success in today's complex world markets.
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