Morningstar Ratings and Mutual Fund Performance

Abstract

This study examines the degree to which the well-known Morningstar rating system is a predictor of out-of-sample mutual fund performance, an important issue given that high-rated funds receive the lion's share of investor cash inflow. We use a data set based on growth mutual funds that is free from survivorship bias and adjusted for load fees to examine the predictive qualities of the rating system. Moreover, we use various performance metrics over different time horizons and sample periods. We also compare the predictive qualities of the Morningstar rating system with those of a naive predictor: simple historical average monthly returns. The results indicate three main findings. First, low ratings from Morningstar generally indicate relatively poor future performance. Second, for the most part, there is little statistical evidence that Morningstar's highest-rated funds outperform the next-to-highest and median-rated funds. Third, Morningstar ratings do no better than the naive predictor for predicting fund performance.