Morningstar has become the go-to source for fund selectors for quite a while now. And this almost monopolistic position apparently has some influence not only on fund flows but also on returns of different investment styles. Itzhak Ben-David and his colleagues have exploited a change in Morningstar’s rating system almost twenty years ago to show how big the influence of the rating agency really is.
Until 2002, Morningstar rated all funds based on past performance, volatility, consistency of returns, etc. independent of the fund’s style. That meant that as one style started to outperform, the funds following this style started to get four- and five-star ratings, while funds following underperforming styles got worse ratings. In 2002, the company introduced its (in)famous style box and started to rate funds within their own style. I think the chart below does make it clear that this had a significant effect on the average ratings of funds with different styles.
Morningstar ratings before and after the introduction of style boxes
Source: Ben-David et al. (2020).
Investors being lazy as they are, tend to follow Morningstar ratings and invest in the highest-rated funds in a given peer group. No matter what consultants and asset allocators claim about the sophistication of their process, in the end, it is past performance that counts because past performance also determines the rating of a fund within its style box. Following ratings or following complex selection processes are in practice all too often just a complicated way of investing in the funds with the best past performance.
The left chart below shows that fund flows both before 2002 and after 2002 follow past performance. But with the introduction of the style box, Morningstar at least managed to reduce the amount of flows chasing past performance. And this apparently also influenced style returns. If investors put a lot of funds to work in funds that had strong performance in the past, they create a herding effect that perpetuates the price momentum of past winners. As a result, value stocks, small cap stocks and other styles tended to have longer-lasting trends in the past and outperformed for longer before mean reversion kicked in.
After 2002, these flows were reduced and, as the right-hand chart below shows, performance became less persistent. In their study, the researchers show that this lack of fund flows has contributed to the lack of outperformance seen in small cap and value stocks over the last two decades. Does that mean that small cap stocks and value don’t outperform at all and it was all a mirage? No. The value effect and the small cap effect have been observed for much longer than mutual funds have been around. But it is clear from this study that the performance of different styles depends on how investors behave. And as their behaviour changes, so do the value premium or the small cap premium.
I am not aware if anyone has done a proper analysis of changing investor behaviour and its impact on styles and factors (except the usual ones showing that after a style is described in the literature its return declines), but I think it pays for both value and small cap investors to think about what has changed in investor attitudes and the investment environment that has reduced the value and size premium. And once you come up with a couple of answers, ask yourself how persistent these changes are going to be.
Fund flows following Morningstar ratings (left), creating style return persistence (right)
Source: Ben-David et al. (2020).