Morningstar vs. The Wall Street Journal...Does It Really Matter ? Not in My Opinion

The WSJ recently had a lengthy article critical of Morningstar and the use of its star ratings. It found the lack of persistency in the star ratings, the use by some advisors of the star ratings as a shortcut in justifying fund recommendations to clients, and the use of fund ratings by mutual fund companies to tout their funds.

This sparked a series of fevered responses by Morningstar here and here and here
For instance one argument by Morningstar's CEO is

• The Journal sees little predictive value in the star rating, but the results show that investors were far likelier to succeed with 4- and 5-star funds over subsequent periods and much more likely to fail with 1- and 2-star funds, on average.

Morningstar also stresses that the ratings "should be used as a starting point" for research.

I could go though and analyze all the back and forth between Morningstar and the WSJ over the star system. But in fact with regards to actually choosing an investment strategy the star system is irrelevant...because it is fundamentally a rating system among actively managed funds (usually how well they do against the relevant index) and actively managed funds should be eschewed in favor of index funds or ETFs.

In the WSJ vs. Morningstar "smackdown They are simply debating a syatem that ranks a a group of investments that should be avoided.

In fact to be fair to Morningstar if you dig down Morningstar often  has some pretty good things to say about indexing and authors that recommend portfolios often make heavy use of index funds. And if you dig even further you will find Morningstar authors stating that the best predictor of future fund performance is the level of fees (not those star ratings). The message is somewhat buried of course because Morningstar's core business is ranking actively managed funds. Telling everyone to forget 90%+ of the funds they rank and just index wouldn't be very good for business.

One author that constantly shows a bias towards indexing is John Rekenthaler who writes on the morningstar advisor website aimed at professionals. In fact in his most recent column he writes

Two weeks back, Barry Ritholtz of Ritholtz Asset Management and Nir Kaissar, a Bloomberg columnist, discussed the merits of active versus passive investing. The debate's outcome was a foregone conclusion; these days, few if any investment writers wholeheartedly support active management. They either recommend passive investing fully or they advocate blending the two approaches, typically by starting with a core of passive investments and then adding active funds as desired.

But Rekenthaller was also on the warpath with the WSJ on the main consumer website with no mention of the indexing alternative and plenty of arguments on how to evaluate the star rating system. The article was enttled Statistical illusions But there is one set of statistics most important to investors that are not an illusion..they should avoid actively managed mutual funds...period/

Just as there is little or no persistency in the star ratings for the actively managed funds it should not be surprising  there is no persistency of returns in actively managed funds vs their relevant index. In fact the only reliable statement that can be made about actively managed funds is that the vast majority of them will fail to outperform their relevant indices.

I didn't even realize how terrible the record is until the always excellent blogger Ben Carlson posted this chart (click to enlarge)

In sum the debate over the efficacy of Morningstar ratings is a case of "looking for the keys under the lamplight". If you are looking for the best choices for your investments then active funds are not the place to look.

Does that mean Morningstar is useless ?...not really if you use their material correctly. Don't even look at the star ratings, don't even look at the actively managed funds. But Morningstar includes a wealth of data about ETFs which can be used for research.  With hundreds of ETFs including multiple ones in basic categories like small cap value Morningstar can offer a valuable tool. I do think the difference in long term performance among ETFs within as market sector can be relevant to an asset allocation. In addition the Morningstar analysis allows one to drill down on the holdings and methodology of the ETF. Very useful data on individual ETFs is also available at ETF,com. So the investor can do some very useful research on various index instruments within categories in Morningstar.

Morningstar has an additional very useful tool I believe in only its premium service. It is something called stock overlap. It is a tool that allows one to analyze an entire portfolio with regards to data such as geographic and industry distribution, p/e, market cap  and percentage of an individual stock in a portfolio. For example since Apple has a high weighting in the overall stock index, the momentum ETF Mtum and large cap growth ETFs like VUG the Morningstar tool is extremely useful in calculating the overall exposure to Apple in a portfolio holding these ETFs.

A very interesting article explaining another way of analyzing overall portfolios appeared at etf.com.in this case with "factors" It can be forund here..

So my conclusion about Morningstar: forget about the stars..and the WSJ/Morningstar debate over them. Forget about using actively managed funds. Make use of the Morningstar material on ETFs and Index instruments (as well as other data such as the excellent material at etf.com) and construct a diversified portfolio of index instruments, rebalance and stay the course.