Models or Stars: The Role of Asset Pricing Models and Heuristics in Investor Risk Adjustment

Abstract

We examine how third party ratings and mandatory benchmark disclosure affect aggregate risk adjustment by retail investors. Morningstar changed its ratings methodology in June 2002. Before the change, the ratings were based on a risk-adjusted performance ranking of all US equity funds and highly correlated to CAPM alphas. After the change, the ranking was calculated within size and book-to-market categories, effectively controlling for these exposures and increasing the rating's correlation to Fama-French (FF3) alphas. Flows strongly correlate with CAPM alphas before the change, but are strongly related to FF3 alphas after. Flows to a matched subset of institutional separate accounts with the same manager and strategy strongly correlate with FF3 before and after the change, but are unrelated to CAPM. Over the broader time period, we find investor flows increasingly respond to FF3 alphas, and this broad trend is explained in part by the ratings' methodology change and improvements in self-declared fund benchmarks, the latter as a result of greater competition. Our results suggest that instead of employing asset pricing models, the average retail investor appears to rely on third-party certification and fund benchmark disclosure to indirectly risk-adjust. Moreover, improvements in rating methodologies and increasing competition drive higher level of sophistication in the risk-adjustment model implied by retail fund flows.