Morningstar Inc.'s recent overhaul of its mutual fund ratings did not correct flaws in its rating system, said William F. Sharpe, Nobel laureate in economics and professor of finance at Stanford University in California.
And Morningstar's rating system is likely to get some competition from Ibbotson Associates, which recently decided to include performance as part of a mutual fund rating system it is developing. Both firms are in Chicago.
Mr. Sharpe, who is studying the mutual fund industry, said a major problem with Morningstar's rating system is the broadness with which it groups mutual funds, giving funds more stars than they might deserve.
"The number of stars depends a lot more on what you do .*.*. than how well you do it," Mr. Sharpe said in an interview. As a result, "big stars go to the funds that happen to stand in the right place," he said.
He said Morningstar's recent changes are a step in the right direction, but Morningstar should have created even more categories for its overall star rating.
Morningstar separated international equity funds from U.S. equity funds at the broad overall star rating level, (Pensions & Investments, Oct. 28), and introduced new separate peer group category ratings that will not be a part of the star rating system.
Mr. Sharpe said it would make more sense for Morningstar to use its new peer group categorization rankings in the overall star rating system, which is used widely in the promotion and selection of mutual funds.
As it stands, the peer group ratings will be an added section in the Morningstar mutual fund evaluation report.
For the new category ratings, Morningstar will group funds into nine basic categories, as well as 11 specialty categories. Based on the securities held, the nine core categories classify stock funds by capitalization (large, medium or small) and investment style (growth, value or a blend). The specialty categories are for concentrated funds: utility funds or technology funds, for example.
The parameters used are the same as those used to create Morningstar's existing style box, which is a graphic Morningstar uses to show a mutual fund's dominant investment style.
Morningstar spokesman Michael VanDam said there are no plans to introduce more investment style categories for the overall star-rating system.
He said the addition of peer group category ratings is an attempt to answer criticisms of Morningstar's system. But he said creating more categories for the overall rating system could result in too many categories, and too many funds getting high star ratings. There would be other methodological problems as well, he said.
Under the current system, Morningstar users have both sets of information: the overall rating system as well as category ratings.
Mr. VanDam emphasized Morningstar does not promote the star ratings as the final answer in selecting mutual funds; the rating is just one piece of information a mutual fund investor can use to select funds.
Meanwhile, Ibbotson Associates executives are working to create their own mutual fund rating system, which will include both a risk and return component.
As first conceived, Ibbotson was going to introduce a mutual fund risk rating system (P&I, March 4), but in response to clients, they decided to include performance as well, said Scott Lummer, managing director.
Like Mr. Sharpe, Ibbotson executives see problems with the way Morningstar categorizes its funds.
"Unless you take style into account, you're not going to have consistent" ratings, he said.
Moreover, he said that using a 10-year period is not very useful because of the limited number of funds with 10-year records. (Morningstar's overall rating system uses a 10-year track record for funds that have them).
The ratings aren't comparing apples to apples if one fund has a three-year record and another has a 10-year record, and fund portfolio managers and investment styles often change dramatically over 10 years, he said.
Because Ibbotson's clients are asking them to, Ibbotson will include performance its upcoming mutual fund risk rating system, Mr. Lummer said.
Nonetheless, Mr. Lummer believes the real value will be in the risk portion of the rating system, which will use a forward looking approach to gauging the riskiness of the mutual fund rather than use just historical returns.