Mutual Fund Talk

Are Mutual Fund Managers Gaming The (Morningstar) System?

While it is certainly true that one can game the system by being risk-averse -- Morningstar values risk-adjusted returns instead of absolute returns -- I still believe in the franchise of Morningstar and the effectiveness of its rating system. At the end of the day, Morningstar's rating is a relative rating comparing each fund to its competition in the same style category, so if everyone is trying to reduce the risk, you can safely bet the trend will turn opposite ways before soon.

In trying to attract and retain assets, Goldman says it believes fund companies are trying to "reverse engineer the Morningstar process" to earn coveted four- and five-star ratings that consumers often solely rely on when researching mutual-fund investment options. "Morningstar did something thoughtful in evaluating what mutual-fund managers say they're doing," says Don Mulvihill, a managing director at Goldman Sachs. "But the fund industry has reacted to it by trying to game the system to get star ratings." The result: lower risk and returns inside the funds.

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So, how might investors respond? Goldman's Mr. Mulvihill says these results strengthen the argument for pursuing a so-called core-and-satellite portfolio. The core of this approach is built around large-cap U.S. and foreign shares owned through index funds, exchange-traded funds or similar funds that charge low fees and take on little more than the risk of the underlying benchmark. Then, with the satellite investments, you venture into other asset categories such as emerging-market debt, real-estate investment trusts and others where "active management is more likely to earn the fees" with benchmark-beating returns.