It's a little-talked-about secret in the investment world that Morningstar ratings are nearly meaningless, and it looks like their Manager of the Year awards are pretty pointless too. (Those links are probably subscriber-only and points to an article in this month's newsletter from Sound Mind Investing.)

Morningstar is much in the news these days with the naming of their "Manager of the Year" awards. How to do they pick these folks, you might ask? If my recent look at their "international" manager finalists is typical of their overall approach, then I think it's safe to say that Morningstar marches to a different drummer than the rest of us. ...

For 2005, their three finalists averaged gains of 20.5%. Our four current foreign funds averaged 32.5%. The two we added in recent months, as you might expect, have great records this year. That's how they climbed to the top of our rankings. But even the other two, both of which we held all year, averaged 26.8%. So, what makes the Morningstar finalists so special?

A Morningstar spokesperson says: "While we certainly seek to recognize managers who've had an outstanding year, we're also looking for those who've built solid long-term results. Simply put, one year of shooting out the lights won't cut it. We also consider the stewardship of the fund and favor managers who have tried to do right by their shareholders."

Aaah... so one good year isn't enough. Ok, how about three? The three Morningstar finalists averaged 24.9% for the three-years ending December 31; our funds averaged 35.9%. Hmmm. Maybe they're looking at five-year records. Given that the past five years included some difficult times, it makes for more of a test. Let's see... theirs averaged 7.0%, ours averaged 9.8%.

As Austin Pryor points out, I'm not sure what could be better "stewardship" than great performance over time. As the first link notes about Morningstar's star rating system:

A table in their report shows that over the three-year period tested, the average U.S. stock fund that sported a 5-star rating on June 30, 2002 went on to return 10.1% annually from July 2002-June 2005. There are a couple of interesting things about this. First, Morningstar says that this return of 10.1% was equivalent to a fund being ranked in the 43rd percentile. Isn't that a little surprising? These are their best funds under a new, improved system, and they're only good enough to rank, on average, in the 43rd percentile? Given that the M* rating system is fairly complicated and that the analysts are some of the sharpest number crunchers around, you would expect better.

Second, the fund groups that received 4-, 3-, 2-, and 1-star ranked in the 49th, 50th, 53rd, and 54th percentiles respectively. Aside from the fact that 5-star funds didn't deliver great performance, we also see that there's not much of a performance difference between the other star groups. 4-star funds are in the 49th percentile while the 1-star group is in the 54th percentile? That just doesn't seem like much of a drop given the "image gap" between a 4-star fund and a lowly 1-star fund.

Don't rely on Morningstar ratings for making investment decisions.

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