- Advertisement -
- Advertisement -

Related

The Power of Mean Reversion in Morningstar’s Five-Star Ratings

Latest Report

- Advertisement -

Stockholm (HedgeNordic) – Mutual funds with a Morningstar five-star rating seldom sustain their above-average performance over time, writes a Wall Street Journal cover story on investment research firm Morningstar’s mutual fund ratings.

The WSJ article discusses the “regression to the mean” phenomenon for mutual funds, particularly for the highest-rated ones. Morningstar rates mutual funds on a one-to-five scale depending on how well they have performed relative to their peer group (after adjusting for risk and sales charges). Within each Morningstar category, the top 10% of funds receive five stars, whereas the bottom 10% receive one star.

Many individuals and institutions, including pension funds, endowments, and financial advisers, use Morningstar’s star ratings system to decide where to allocate capital. However, WSJ’s detailed analysis points out that the rating system does not serve as a good indicator of future performance. Interestingly enough, only 12% of the funds awarded a five-star rating remained in the top category over the next five-year period. An alarming 10% of those funds performed so poorly that they received a one-star rating.

The analysis shows that ratings of one-star and five-stars rated funds converge after ten years. The average score for a five-star fund tends to decline to three stars, and for a one-star fund, it increases to 1.9 stars.

Fund companies “heavily advertise their star ratings”, says the WSJ, with investment flows often pouring into the funds freshly awarded with five stars. Soon after the article’s publication, Morningstar officials claimed the rating system should only be a first-stage screen of potential investments rather than a predictor of future performance. In defence of Morningstar, informed investors should be well aware of the “regression to the mean” phenomenon.

The regression to the mean takes place typically because most phenomena include a deterministic and a random component. Indeed, the investment skills (the deterministic factor) of fund managers matter quite a lot, but so does luck (the random factor). When a fund is registering exceptional results in a given year, most probably a talented person is having a lucky year. Of course, talent is reasonably stable over time, but luck is not. And after observing a string of exceptional performance, the fund managers are likely to see their returns regress to the mean, as they run out of luck.

 

Picture (c) Blotty – Dreamstime.com

Subscribe to HedgeBrev, HedgeNordic’s weekly newsletter, and never miss the latest news!

Our newsletter is sent once a week, every Friday.

Eugeniu Guzun
Eugeniu Guzun
Eugeniu Guzun serves as a data analyst responsible for maintaining and gatekeeping the Nordic Hedge Index, and as a journalist covering the Nordic hedge fund industry for HedgeNordic. Eugeniu completed his Master’s degree at the Stockholm School of Economics in 2018. Write to Eugeniu Guzun at eugene@hedgenordic.com

Latest Articles

From Beef to Bitcoin: August’s Wild CTA Ride

In August 2025, the CTA sub-index of the Nordic Hedge Index edged lower after two positive months, reflecting mixed performance among managers. Strong gains...

Lauri Ehanti to Leave Aalto University Endowment After 14 Years

Lauri Ehanti is leaving Aalto University’s endowment fund after 14 years in various roles, most recently as Head of Investments. His responsibilities will be...

Othania’s All-In-One Fund Celebrates Five Years

Danish fund boutique Othania is celebrating the five-year anniversary of Othania Balanceret Makro, its all-in-one fund blending equity, bond, and alternatives exposure through Exchange...

Atlant Fonder Crosses SEK 10 Billion Milestone

Strong performance and steady inflows have propelled alternative fund boutique Atlant Fonder past the SEK 10 billion milestone in assets under management. Its flagship...

Nordea PM Joins Lancelot Global as Co-Manager

Lancelot Global, a long-only equity fund with flexible net exposure ranging from 60 to 120 percent, has strengthened its portfolio management team with the...

Quirky Questions – or, A Peoples Business

If asset management were only about numbers, we could all go home and let the calculators get on with it. But calculators are dull...

Allocator Interviews

In-Depth: High Yield

Voices

Request for Proposal

- Advertisement -
HedgeNordic
Privacy Overview

This website uses cookies so that we can provide you with the best user experience possible. Cookie information is stored in your browser and performs functions such as recognising you when you return to our website and helping our team to understand which sections of the website you find most interesting and useful.