The evidence is in. Morningstar Inc.'s star ratings of mutual funds influence cash inflows into funds.
"While a direct, causal relationship is impossible to establish, there is an undeniably strong correlation between cash flows and Morningstar's star rankings. Furthermore, this correlation has grown substantially over the last several years, particularly for certain broad categories of funds," said an analysis by Financial Research Corp., a Chicago mutual fund consultant.
While in 1993 funds with four- or five-star ratings accounted for just more than half of the industry's stock fund gains in net sales, by the first quarter of 1996, such funds accounted for nearly 80%. Funds not rated by Morningstar, including multiple-share classes of rated funds, are excluded. If unrated share classes were included, four- and five-star products' share of U.S. stock fund inflows would rise to a whopping 90% for the first quarter.
Stars have the greatest influence on domestic equity funds. Virtually all of the more than $66 billion in positive cash flows of rated funds for this year were in four- and five-star funds. Nearly two-thirds of the gain were in five-star offerings alone. Funds with fewer than four stars suffered aggregate net redemptions of $8 billion, with flows in one-, two- and three-star categories all negative. Of the 788 funds in the bottom three categories, 63% endured net redemptions. Of 480 funds with four or five stars, on the other hand, just 16% saw redemptions.
The favoring of five-star funds was strongest among riskier funds such as small- and midcapitalization funds and technology and growth stock funds. Flows were more balanced between the top two ratings for equity-income, growth and income and Standard & Poor's 500 index funds, with more flowing into four-star funds than five-star funds.