About Those Morningstar Ratings

It seems they don’t measure much other than how well the fund manager manages his fund to get a high Morningstar rating. Talk about useless.

The WSJ reports:

Mutual Funds AvoidRisk to Lift Ratings
By JEFF D. OPDYKE

February 28, 2007; Page D2

Is your mutual fund too average? There's a good reason why you might feel that way.
Returns for mutual funds are increasingly congregating around a broad middle -- often failing to equal their benchmarks, according to new research from Goldman Sachs Group Inc. Goldman found that large-company equity mutual funds have consistently failed to beat their benchmarks over the past 20 years. This is a result of fund companies and fund managers sidestepping risk for a variety of reasons, Goldman concludes. One reason: Funds are trying to reduce their price volatility to earn higher Morningstar ratings.
In trying to attract and retain assets, Goldman says it believes fund companies are trying to "reverse engineer the Morningstar process" to earn coveted four- and five-star ratings that consumers often solely rely on when researching mutual-fund investment options. "Morningstar did something thoughtful in evaluating what mutual-fund managers say they're doing," says Don Mulvihill, a managing director at Goldman Sachs. "But the fund industry has reacted to it by trying to game the system to get star ratings." The result: lower risk and returns inside the funds.

And a top Morningstar exec doesn’t even doubt that this gaming of the system is taking place:

Don Phillips, managing director at Chicago-based Morningstar Inc., says the investment-research company has also noticed that funds are clustering around the middle. Part of the reason, he says, "probably is us." But other reasons, he notes, are that "managers who stuck their neck out and lost in recent years, lost their jobs, so risk taking is penalized."

Of course despite this interesting research finding, Goldman Sachs can’t resist the opportunity to fuel the eternal hope that active management can work somewhere. Since they know no one doubts that active management doesn’t work for large cap stocks, they make the feeble argument that it works in other asset classes :

So, how might investors respond? Goldman's Mr. Mulvihill says these results strengthen the argument for pursuing a so-called core-and-satellite portfolio. The core of this approach is built around large-cap U.S. and foreign shares owned through index funds, exchange-traded funds or similar funds that charge low fees and take on little more than the risk of the underlying benchmark. Then, with the satellite investments, you venture into other asset categories such as emerging-market debt, real-estate investment trusts and others where "active management is more likely to earn the fees" with benchmark-beating returns.
I would never recommend emerging market debt (the risk/return is too unattractive) but I know little evidence that active management beats indexing for REITS .
This “core and satellite” approach is the latest refuge of the brokerage and mutual fund industry. They can’t fight the argument for indexing, so they argue that the “core” of the portfolio should be indexed and a “satellite” portion of the portfolio should be allocated to active (and high fee) managers such as those managing hedge funds. There is no rationale for their approach.