New Study Shows Mutual Fund Rating Services Possess Little Ability to Predict Winning Funds

Although mutual fund rating services state that their ratings should not be used as signals of future performance, the simple fact is that investors and financial consultants do use the ratings to choose funds in which to invest. A new study, conducted by researchers at Pace University’s Lubin School of Business, concludes that mutual fund rating services like Morningstar and Value Line show little ability to predict winning funds, and cautions those who use ratings as signals of future performance.

Contact: Bill Caldwell, Office of Public Information, Pace University, 212-346-1597, wcaldwell@pace.edu

New Study Shows Mutual Fund Rating Services Possess Little Ability to Predict Winning Funds

New York, New York – January 15, 2003 – Although mutual fund rating services state that their ratings should not be used as signals of future performance, the simple fact is that investors and financial consultants do use the ratings to choose funds in which to invest. A new study, conducted by researchers at Pace University’s Lubin School of Business, concludes that mutual fund rating services like Morningstar and Value Line show little ability to predict winning funds, and cautions those who use ratings as signals of future performance.

“Investors should be very cautious about interpreting mutual fund ratings,” said Matthew Morey, Ph.D., associate professor of finance at the Lubin School and author of the study. “Ratings should be used as measures of past performance, and investors should remember that the ratings are of dubious help in terms of predicting future winning funds.”

The new Pace study examines two issues. First, the study documents the mutual fund ratings/rankings methodology of the Morningstar, Value Line and Lipper Analytical systems. Second, the study investigates the out-of-sample predictive ability of the Morningstar and Value Line ratings.

The findings are as follows:

1. Analyzing the ratings methodologies, the researchers find the Morningstar system “emphasizes expense, load and risk-adjusted returns where risk is defined as downside risk”. On the other hand, the Value Line system “emphasizes the persistence of fund performance, i.e., the ability of a fund to consistently out-perform other funds in terms of simple (non-expense, non-load, non-risk adjusted) returns. There is also a difference in the time horizons that the two systems examine: Morningstar uses a system that emphasizes a fund’s long-term performance (up to 10 years), while Value Line uses a shorter period of time (up to five years). While both Morningstar and Value Line rate mutual funds on a scale of 1 to 5, the Lipper Analytical system, conversely, separates funds into many styles that are determined by Lipper itself, and then ranks funds in each of the defined styles from top to bottom by their total return. Lipper does not provide any formal ratings for funds.”

2. In terms of the predictive ability of the Morningstar and Value Line ratings, the researchers use “an approach that is robust to survivorship bias and load-adjusted returns.” Furthermore, the researchers use four different measures of “out-of-sample” performance and also examine alternative ratings systems that are based on simpler methodology than the Morningstar and Value Line systems. The researches note three findings in this analysis:

a) “Neither of the ratings systems, nor the alternative ratings systems, are able to successfully predict winning funds. Specifically, the researchers find that the difference in out-of-sample performance between top-rated and median-rated funds is never significant with the correct signs and sometimes actually has the incorrect signs.”

b) “There is some ability using risk-adjusted measures to predict losing funds, as the lowest rated funds do have lower levels of out-of-sample performance than other funds.”

c) “There is some weak evidence that the Value Line system actually predicts future performance better than the Morningstar system. However, this result only holds for the poor performing funds and only for the Sharpe index and Jensen alpha performance metrics. The Morningstar system is able to better predict future performance using the more complicated 4-index alpha performance metric.”

This study appears in the current issue of the Journal of Investment Consulting. For a copy of the paper, email wcaldwell@pace.edu .

Pace is a comprehensive, independent university with campuses in New York City and Westchester County, and a Hudson Valley Center located at Stewart International Airport in New Windsor. More than 14,000 students are enrolled in undergraduate, graduate and professional degree programs in the Dyson College of Arts and Sciences, Lubin School of Business, School of Computer Science and Information Systems, School of Education, Lienhard School of Nursing and Pace Law School.

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