Abstract
Morningstar ratings are important determinants of fund flows. We derive the finite-sample distribution of the underlying Morningstar risk-adjusted return (MRAR) and show that it exhibits high variance and bias. High variance explains the observed low absolute persistence of Morningstar ratings. The bias is increasing in fund volatility, perversely rewarding funds for taking on risk. This explains why 1-star ratings are more persistent than 5-star ratings. These theoretical findings are confirmed in a bootstrap analysis of the joint empirical distribution of mutual fund returns. Lastly, as an expected utility measure, the MRAR is meaningful at the portfolio-level but not the fund-level.
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