Morningstar Ratings Questioned

Morningstar Influence Grows; Some Concerns Remain

By Arden Dale Of DOW JONES NEWSWIRES

NEW YORK — Morningstar Inc. (MORN) casts a long shadow over the mutual-fund industry.

Founded in 1984, the Chicago investment-research firm went public in May and has been growing by leaps and bounds ever since. Last week, Morningstar reported that its earnings increased by 84% since the third quarter of last year.

The financial results speak volumes about Morningstar’s popularity with financial advisors, a niche that has burgeoned as the nation’s baby boomers near retirement. Sales of the firm’s Advisor Workstation – a Web-based investment-planning system used by advisors – have been a major driver of the earnings success. Specifically, Morningstar said U.S. licenses for the workstation increased to 102,606 as of Sept. 30, 2005, from 72,190 as of Sept. 30, 2004.

Despite that success, concerns about Morningstar persist among advisors and others in the industry. Among them are that Morningstar may have a possible conflict of interest because it opines on funds to which it also sells data. Another long-standing criticism is that the company’s well-known star ratings can mislead investors. Morningstar rates mutual funds with from one to five stars, based on how well the funds have performed, after adjusting for risk and accounting for all sales charges, in comparison with similar funds.

Don Phillips, a managing director of Morningstar, acknowledged that the firm has heard some of those criticisms. “There’s always resentment of those who are winning in the marketplace,” said Phillips. The important thing, he added, is how Morningstar responds. By listening and making changes when warranted, Morningstar has shown that it understands the important role it plays as an advocate for investors. “We don’t turn a deaf ear to criticisms,” said Phillips.

David B. Yeske, a financial planner at Yeske & Company Inc. in San Francisco, studied Morningstar’s star ratings as part of his doctoral work, and concluded they aren’t a good indicator of future fund performance. Later, Stanford University Professor William Sharpe, a Nobel laureate, published a study that also raised questions about the ratings. Morningstar subsequently made some changes to the way it calculates the ratings, but the ratings still depend on historical measures, which “typically have poor predictive power,” said Yeske.

“Morningstar uses lots of cautionary language when talking about its ratings, noting that these are merely funds that have performed well in the past, but there would be no point in reporting them in the first place unless there was some implication that past performance had some predictive power,” said Yeske.

Neil D. Hackman, president and chief executive of Oak Financial Group, a fee-only investment-advisory firm in Connecticut, said he uses the star ratings when talking to clients about funds because they offer a quick snapshot for investors. Nonetheless, he does his own analysis of the funds because he finds some aspects of the ratings confusing. As for the opinions of Morningstar analysts on funds, Hackman said he has certainly disagreed with them at times.

Nonetheless, fund companies in the retail mutual-fund business can’t afford to ignore what Morningstar says about their products. “Go down the list of anyone who has retail mutual funds, and they will have to say, yes, it impacts their business,” said Robert Lee, a Keefe, Bruyette & Woods Inc. analyst who covers asset-management firms.

That influence came up during a conference call in October to discuss Janus Capital Group Inc.’s (JNS) earnings. “I think we have to acknowledge that the Morningstar ratings still matter enormously,” said Janus President and Chief Investment Officer Gary Black, who will become chairman of Janus on Jan. 3. During the call, Black said the Janus Contrarian Fund got a big boost when its Morningstar ratings rose. It “went from three stars to four stars and it’s a top decile, up one percentile and, almost overnight, the flows went from being negative to positive,” said Black.

Still, Yeske and others say some advisors put undue emphasis on the ratings when selling funds to clients. “I think these reports are particularly useful to the wirehouse types, who are out to sell anything, they don’t care what, so touting the latest five-star fund represents no philosophical disconnect for them,” he said. “Every month, they’ll just push the latest batch of funds to get the top rating.”

Phillips, of Morningstar, said of the star ratings that the company “has never run an ad saying ‘follow the stars to riches.’ We’ve never promoted the star rating as the be all and end all,” he said. “We describe it as a grade on past performance.”

Nonetheless, while Morningstar is careful to point out risks and warn investors that its ratings don’t foretell the future, “the star system is, unfortunately, used by people as a shopping tool – just as they might use the ratings of Consumer Reports to purchase a product,” said John Demming, a spokesman for Vanguard Group, who added that in general Morningstar has “done a great job educating investors about mutual funds.” Despite his concerns about the star ratings, Demming said, the company has taken care to say they don’t predict future performance.

When evaluating mutual funds, Vanguard encourages investors to look at the fundamentals of investing and to focus on the quantitative, measurable characteristics of a fund, including costs, risks, taxes and manager tenure, Demming said. “We all know that past performance isn’t an indication of future results for many reasons, including markets changing, fund managers changing, investment strategies or sector allocations that succeed in one period doing poorly in the next.”

Another perception within certain quarters of the industry is Morningstar has a conflict of interest at its core, given that it ranks funds run by companies to which it also sells research.

But Phillips noted that Morningstar doesn’t charge funds to be rated and rates them whether or not they want to be rated. “I think it’s as clean a business model as has existed in investment research,” he said.

Roy Weitz, publisher of the Website FundAlarm, said he thinks Morningstar generally does good work, but its dominance in the marketplace is due the fact that it doesn’t have much competition.

“Whenever you have a strong presence in an industry that doesn’t have strong competition keeping it in line, it does have the opportunity to go awry,” said Weitz. “They need to have a really good internal compass in terms of avoiding conflicts of interest.”

Lipper Inc., the Denver research arm of Reuters PLC (RTRSY), also ranks funds and tracks fund expenses and other data, but it isn’t as widely known by average investors. Lipper, founded in 1961, has chiefly done business within the fund industry itself, but has recently been expanding to advisors. Lipper declined to comment.

Phillips acknowledged the singular status Morningstar has with investors on Main Street.

“I do think that Morningstar has a tremendous amount of power, and that we wield it in as fair and balanced a way as we can,” he said. “We take that responsibility seriously.”