Many investors are overwhelmed by the sheer number of investment options available to them. You can look on financial websites, follow financial cable news, or even sign up for an investing service. It is all to try to make sense of a complicated industry. Financial markets are complex and it’s easy to see why many investors tend to get overloaded. There’s a whole cottage industry claiming to demystify the stock market. Some are scams, but some do provide valuable services to professional and retail investors alike. Even then, it’s important to understand the limitations of having someone else do the research for you. 

Morningstar rates funds based on risk-adjusted return for similarly grouped funds.

Large-cap growth funds will be compared to other large-cap growth funds, or what’s called a peer group. The better a fund performs based on the amount of risk taken, the higher the star rating from Morningstar. This is an important point as investors tend to only look at absolute performance to make investment decisions. If my fund manager doubled my money, I’d be happy. But if that same fund manager doubled my money by gambling it at the casino, then he’d be fired. The idea of taking risk to generate returns has been around long before Morningstar, but no one had an easy-to-understand way to measure it. Ever since being created in 1984, the star rating quickly became (and generally still is) the standard to grade investment funds.  

Risk-adjusted return is an important concept that we at Consilio Wealth Advisors agree with.

Understanding how an investment generated returns in the past could be a good assumption of how that same investment would generate returns in the future. The problem is the risk-adjusted return measurement is purely a look into the past. You’ve probably seen the disclosure that says, “Past performance does not guarantee future results”. With good reason! The past is the past and the future does not always reflect it. 

We use risk-adjusted return as a component to measure either manager skill or to get a sense of how an asset may behave in certain markets. It is part of an investment screening process, not the whole thing. Morningstar ratings are based solely on this concept. The star rating became massively popular among professional and retail investors because it is easy to use and understand. A fund with a five-star rating deserves attention and the corresponding flow of money. The manager did great right?

Right. Managers prior to receiving 5 stars typically had a rules-based investment process. If a stock fit their screening parameters, they would buy it. If that stock no longer fit the parameters, they would sell it. Simple. However, research has found that after receiving five stars from Morningstar, performance severally drops off. More troubling, the manager also took on more risk. (Kiss of Death: A Five Star Morningstar Rating? Morey, 2003) 

The five-star ratings attract a lot of new money which most fund managers were happy to take.

The problem was that their success was predicated on a manageable investment pool. One million dollars is much easier to invest than one billion. Think of it as a math problem. Managers who were successful in deploying a smaller amount of money may not be as successful with a larger amount of money. Their success has outgrown their rules-based investment process. They start bending their own rules and begin picking up names that don’t fit the parameters. The extra money has to go somewhere because if they took the cash and sat on it, they are doing a disservice to all of their investors. 

The Morningstar ratings are not completely without merit.

Imagine a scale that is broken but it is consistent when weighing two different objects. As long as the scale is consistent between the two, I have a useful scale. I can get an idea of what objects are heavier than others. To give Morningstar credit, its rating scale has not changed in 40 years. The consistency gives investors insight into what may be good relative to other options.  

The problem is financial advisors for decades just used five-star ratings to invest their clients’ assets. We think that’s a low and completely backward-looking standard. 

Take an example of a regional bank ETF which is rated two-stars by Morningstar. The rating makes sense in a backward viewpoint because these banks tend to be more traditional and reliant on interest rates. Bigger banks don’t rely as much on loan business because they have many types of businesses, like trading desks. Regional banks were hit hard by the long-term decline in interest rates, all the way down to nearly zero in the US. If we think rates are going higher, then regional banks will probably benefit most because they can earn more interest on their loans. 

A typical investor using Morningstar wouldn’t even consider investing in regional banks. They may have the same expectation as us with rising rates, but they’ll gravitate toward another investment altogether. 

Disclosures: 

The information provided is for educational and informational purposes only and does not constitute investment advice and it should not be relied on as such. It should not be considered a solicitation to buy or an offer to sell a security. It does not take into account any investor's particular investment objectives, strategies, tax status or investment horizon. You should consult your attorney or tax advisor.

The views expressed in this commentary are subject to change based on market and other conditions. These documents may contain certain statements that may be deemed forward‐looking statements. Please note that any such statements are not guarantees of any future performance and actual results or developments may differ materially from those projected. Any projections, market outlooks, or estimates are based upon certain assumptions and should not be construed as indicative of actual events that will occur.

All information has been obtained from sources believed to be reliable, but its accuracy is not guaranteed. There is no representation or warranty as to the current accuracy, reliability or completeness of, nor liability for, decisions based on such information and it should not be relied on as such.

Consilio Wealth Advisors, LLC (“CWA”) is a registered investment advisor. Advisory services are only offered to clients or prospective clients where CWA and its representatives are properly licensed or exempt from licensure.

For additional information, please visit our website at www.ConsilioWealth.com.