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Research Review: Morningstar Fund Ratings

Morningstar has recently been in some hot water, as a recent paper highlights that they may be assigning too high ratings to several bonds funds. The author of the paper (Chen, Cohen, Gurun) found the difference when comparing regulatory filings and the holdings morningstar have in their database as reported by the underlying managers. To their amazement, they found that the fund typically reported less risky positions to MorningStar. This typically resulted in higher ratings and thus a higher potential for higher flows.

Don’t Take Their Word For It: The Misclassification of Bond Mutual Funds
We provide evidence that mutual fund managers misclassify their holdings, and that these misclassifications have a real and significant impact on investor capital flows. In particular, we provide the first systematic study of bond funds’ reported asset profiles to Morningstar against their actual portfolios. Many funds report more investment grade assets than are actually held in their portfolios, making these funds appear significantly less risky. This results in pervasive misclassifications across the universe of US fixed income mutual funds by Morningstar, who relies on these reported holdings. The problem is widespread- resulting in about 30% of funds being misclassified with safer profiles, when compared against their actual, publicly reported holdings. “Misclassified funds” – i.e., those that hold risky bonds, but claim to hold safer bonds– outperform the actual low-risk funds in their peer groups. “Misclassified funds” therefore receive higher Morningstar Ratings (significantly more Morningstar Stars) and higher investor flows due to this perceived outperformance. However, when we correctly classify them based on their actual risk, these funds are mediocre performers. Misreporting is stronger following several quarters of large negative returns, and it is strong at the fund family level. We report those families that have the highest percentage of misreported funds in the sample.

NBER Working Paper No. 26423 or https://papers.ssrn.com/sol3/papers.cfm?abstract_id=3474557

Morningstar refutes that this is a problem: https://community.morningstar.com/t5/Bond-Squad/Misclassification-of-Bond-Mutual-Funds/td-p/29432

More coverage here:

The lesson learned here is investors always needs to perform due diligence, regardless of third party firms. FT previously pointed out the rating miss for H2O’s funds.