Do Morningstar’s ratings work or not? (revisited)

Last week in the WSJ, Joe Light shined some light on a study that took issue with Morningstar's ability to forecast winning mutual funds. The paper looks at Morningstar's overweighting of "corporate culture" as the major input into what the research firm calls, "corporate stewardship".

Corporate culture is one of the mushier components, answering questions like “do talented investors spend their careers at this fund firm?” To see what value the culture rating adds, Pace University professors Aron Gottesman and Matthew Morey took Morningstar’s corporate culture ratings and compared them to fund performance between 2005 and 2010, finding that the two don’t necessarily go hand-in-hand. (Can Corporate Culture Predict Mutual Fund Performance)

Morningstar responds

Well, the mutual fund rating firm wasn't going to let this slide without a fight. The WSJ published Morningstar's retort:

There are some serious flaws in the Gottesman-Morey study. First, we’re skeptical of any study that finds that fund expenses have no predictive value. Expenses have been shown time and again to be predictive of performance. We think it’s also important to point out that Gottesman and Morey did find that a high Culture Score was strongly associated with low fees, long manager tenure, low turnover, and fund survival. These are all very positive qualities in a mutual fund... (Morningstar challenges study that questions its ratings)

Morningstar's Ground Hog Day

Predicting winning mutual funds is an extremely hard task. Given the money-attraction cycle a successful fund manager experiences, most outperforming funds simply revert to the mean. So, Morningstar -- or anyone else in this space -- has its work cut out trying to filter out the noise. Just a few years ago, I wrote about Morningstar's surprisingly introspective research into Joel Greenblatt's Magic Formula results. The author of The Little Book that Beats the Market has an approach that apparently trounces most actively managed funds. If fund returns are scattershot across time, research firms attempting to predict future results are by nature just going to have a hard time. Morningstar's attempt to capture the core qualities of good asset management are as good as any.

Any disruptive competitors?

This seems to me to be a good place for industry disruption from the cadre of new financial startups aiming to disrupt the current financial industry status quo. Morningstar ($MORN) has a $3B marketcap with over $600M in revenues. Morningstar's approach has applied 3rd-party measurement on top of a wily and wooly industry but that doesn't mean there aren't other approaches. A startup targeting this space could expect to siphon away revenues from the incumbent(s) but also expand the entire pie.