We’ve all been to parties where assorted guests are hanging by the back door making snide remarks about the hosts.
But when the party is the annual Morningstar Investor Conference and the comments are coming from representatives of some top names in the fund world … it’s something for average investors to consider.
So when 1,400 fund executives, investment advisers and individual investors converged on Chicago last week for the annual Morningstar event, there was an undercurrent that hinted at the love-hate relationship that consumers and pros have with the foremost independent research firm in the fund business.
Morningstar clearly is the power broker in dealings between individual investors and fund companies. Studies have shown that more than 90 percent of all money flowing into mutual funds goes into issues carrying four- or five-star ratings. Morningstar’s system of “style boxes” is designed to describe the way a fund manager operates, but is widely used as an asset-allocation guide. The tools are tremendous, but the public also feels the wrath of unintended consequences stemming from their widespread acceptance.
It’s not necessarily Morningstar’s fault that the tools are sometimes misused, but there’s no denying the issues. They center around:
Morningstar has said from the very beginning that its star ratings are not predictive but that hasn’t stopped investors and financial advisers from wishing on the stars.
Because investors base decisions on ratings, a loss of stars can mean money flees the fund.
And with manager compensation frequently being tied to asset growth – and with the flow of new money resting on the ability to get a high star rating – some critics suggest that top-rated managers are sometimes encouraged to take additional risks to stay at the top.
Morningstar officials counter that the ratings are adjusted for risk. Moreover, it’s not easy to stay at the top of the heap.
Morningstar’s style boxes look like a closed-in tic-tac-toe board, and allow a fund to be put into one of nine categories. Again, the box is meant to be descriptive, to show what a fund has done rather than what it might do next.
The problem is that the financial advisory community has turned the boxes into straitjackets for money managers. They want a fund confined to a certain box, so that the adviser can build a portfolio certain in the knowledge that the fund represents a certain geography.
“Morningstar has to recognize that the style box is restrictive – whether they meant it that way or not – and they have to go beyond it,” says Brian Posner, chief executive officer at ClearBridge Advisors and a featured panelist at the Chicago event. “Most managers will tell you they are about preserving and creating wealth … but then they will tell you that they have to stay in a certain geography because if they make a change, it will show up in the style box and they will be punished for it by investors.”
Furthermore, investors have tried to build portfolios to fill the various parts of the grid, and fund companies have responded by creating funds to cover each part of the box; the result is too many funds in the average portfolio and in the industry.
For investors, the offshoot is simple: Decide if you want funds that are rigid in what they do, or that have some flexibility. If you don’t want management that is limited in how it acts, pick funds that have the ability to go anywhere, or ride along with the manager when they tilt the fund a bit toward a certain style or cap size.
Use Morningstar’s tools as intended – as helpers, not decision-makers.
Chuck Jaffe is senior columnist for MarketWatch. He can be reached at jaffe@morningstar.com or Box 70, Cohasset, MA 02025-0070.
