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Morningstar, Wall Street Journal Rankings Loom Large on Funds

Two new scholarly articles examine the effect of the public media coverage on mutual funds. In one recent paper, researchers from the University of Rochester examined the effect of a fund’s inclusion in the Wall Street Journal’s “Category Kings” feature which shows the top ten funds by total return in a number of investment categories. The authors found that funds on the list experienced a 31 percent average increase in quarterly capital flows compared to those funds which just narrowly missed making the list. They found that the increase due to the publicity was 7 times larger than would be expected due to performance-related flows. Additionally, sister funds of those included also experienced increased flows. In an apparent attempt to chase these benefits, the authors found that funds near the cutoff for the lists experienced increased tracking error volatility at the beginning of the final month of the quarter.

The second paper examines the effect of Morningstar ratings on fund manager turnover. Morningstar’s ratings are derived by “calculating a risk-adjusted return for each fund that equals the fund's return after accounting for all loads, sales charges, and redemption fees minus a risk penalty that accounts for variation in the fund's monthly performance.” Funds are then ranked by category in a five-star system. Reviewing single-manager funds in which the manager had been in place for at least two years, the authors found that a fall from five stars to four increases the likelihood that a manager will be replaced by 9 percent and a fall from three stars to two stars results in a 34 percent increase of the likelihood of manager replacement. While these results would seem to confirm a common sense understanding, the paper finds that a change in Morningstar ratings are a better predictor than other measures such as risk-adjusted and objective-adjusted returns and one-year and three-year alphas.

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