Morningstar star prediction - Signal to noise is low

Morningstar star ratings - Do they really work or are they a dangerous tool? This is important to revisit given the increased number of hedge funds that now have '40 Act fund structures that are ranked by Morningstar.

Like most tools, if they are used inappropriately, there will be problems. There is an ongoing controversy between Morningstar and others on the signaling value of a 5-star rating or for that matter any ranking. The ranking today may not provide predictive power on future ranking or performance. Our view is that their ranking system is a good start for analysis but should not be used as a definitive measure. Some of the problem with the ranking are associated with just understanding what is being measured.  

The ratings are a risk adjusted ranking of funds within a defined investment category. While the approach accounts for downside risk, the stars are nothing more than a ranking system. A 5-star fund will be in the top 10 percent of the funds within the category. Morningstar grades on a curve, it is hard to maintain a 5-star rating. It is backward-looking based on performance and says nothing about the quality of the manager, their philosophy, or what the fund will do in the future other than to say for the sample periods it has a high ranking. Morningstar also has analyst rating which are forward-looking and rank by a colored shield but this approach is not as popular as the risk rating. The ranking is also weighted by the time outstanding for the fund. 

We think the ranking value may have less signaling in alternative investments for two reasons. One, the sizes of the categories has changed significantly over the last few years with the growth in alternative investment funds. Two, the categorization of alternative investments is not as precise as in some of the more traditional categories. Hence, there may be noisier investor information in these ranking measures.

Predictability comes with a positive correlation between ranking today and the performance tomorrow. The research on predictability is mixed. A ranking could still remain high but there can be a decline in returns. A ranking could fall and there be better risk-adjusted performance next period. The risk ranking does to account for any changes in the fund structure. Hence, it is hard to place too much emphasis in the ranking until you define carefully what is being measured. 

• Do you want to predict return? 
• Do you want to predict future rankings? 
• Do you want to predict absolute return to risk? 
• Do you want to make a prediction about return or ranking versus other categories?

There needs to be more research on the value of rankings for alternative investments in order to provide investors with better advise on allocation to these growing categories of funds.