The hidden benefit in Morningstar fund ratings

Fund managers love and loathe Morningstar ratings in equal measure. If they have a good rating, they love it because so many investors follow these ratings that a four- and five-star rating triggers increased inflows into the fund. When their rating is low, they don’t like it all, because that is often followed by outflows. One common criticism of Morningstar ratings is that it merely reflects past performance and is not indicative of future returns. And there is some evidence that Morningstar ratings are to a large part driven by past risk and return of the fund. But even so, there is more to these ratings and this hidden feature is positive for the market and fund managers.

One problem that many funds encounter is that their returns are not scalable. They may have good returns, which triggers new investor flows into these funds but then returns start to decline because the strategy of the fund isn’t scalable. Maybe the strategy relies heavily on fast portfolio adjustments to changing market circumstances but as the portfolio becomes larger, the fund takes longer and longer to trade positions and gradually loses its edge. Or the fund creates much of its performance through investments in smaller companies or other less liquid investments. Larger funds can’t just invest more into these smaller companies and are thus forced to branch out and invest in other assets with lower returns, thus once again eroding their returns.

In other words: Are Morningstar ratings making the scalability problem worse or is Morningstar recommending funds that have good and scalable returns?

Maurice McCourt and Qi Zeng from the University of Melbourne looked at the Morningstar ratings of US mutual funds, their scalability and the flows in response to Morningstar ratings. And they fund that – wittingly or unwittingly – Morningstar provides higher ratings to funds that have higher returns and are underfunded relative to their optimal capacity. They also find that Morningstar ratings do trigger investor flows into highly rated funds and away from lower-rated funds.

The combination of these two effects makes funds more efficient, in a sense. Funds that have good returns and are scalable tend to get a higher rating while larger funds tend to get lower ratings. This triggers flows out of the large funds and into the smaller, underfunded funds thus inadvertently helping to improve the returns of both small and large funds. The smaller, underfunded funds get more assets and can benefit from economies of scale, while the large, overfunded funds shrink a little bit and thus come closer to their sweet spot.

I doubt that this is a conscious effort by Morningstar, but it is an underappreciated benefit of Morningstar ratings. Whether fund managers of large, overfunded funds see it that way, remains open.

Average ratings of smaller, underfunded funds vs. larger, overfunded ones

Source: McCourt and Zeng (2022)