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Style drift and star ratings

M* recently reclassified VPMCX as large cap blend. It had been classified large cap growth even though its portfolio had been in the blend column since 2018.

Its performance looked very poor compared with its "peers": 50th percentile (2018), 84th percentile (2019), 94th percentile (2020). (Though in 2021, with value ascending, it looked great - somewhere in the top 5%).

As a result of its long term "poor" performance, it had been rated 2 or 3 stars earlier this year. But with the reclassification, it's suddenly a five star fund. Nothing has changed. Its half brother POGRX is a bit more growthy, so M* has left it in the LCG category. As a result, that fund sports a 2 star rating.

An example how even unintentional drift affects star ratings is FSMAX. It tracks the S&P 500 completion index. M* writes: "This has been one of the strongest performers in the mid-cap blend category over the trailing 10 years through July 2020." But it has been on the blend/growth boundary since at least 2017, and M* recently reclassified it as growth. So this perennially strong performer is now rated 2 stars.

I'm not faulting M* here. Funds that do not sit near the center of a style "box" have a good chance of being over- or under-rated. This will happen regardless of what box they're dropped into.

Comments

  • Oh, I am thinking I would fault them a bit. They know how their star system is used, and when it lacks nuance and context to this extent, and when star changes seem capricious, what's a consumer to do? (As an instructions writer, I know the answer: read deeper, read harder, RTFM. So why have stars in the first place? CU does a better job.)

    This is just a remarkable, damning summary, which I repost for emphasis:

    ... reclassified VPMCX as large cap blend. It had been classified large cap growth even though its portfolio had been in the blend column since 2018.
    Its performance looked very poor compared with its "peers": 50th percentile (2018), 84th percentile (2019), 94th percentile (2020). (Though in 2021, with value ascending, it looked great - somewhere in the top 5%).
    As a result of its long term "poor" performance, it had been rated 2 or 3 stars earlier this year. But with the reclassification, it's suddenly a five star fund. Nothing has changed.
  • edited June 6
    Yesterday, in the June M* Fund Investor newsletter, I noticed that VPMAX was now classified as a Large Blend fund. As you noted, a mutual fund's star rating and category rank can change dramatically when a fund is moved to a new category.

    I've had a similar experience with MIEIX.
    On 09/30/20, MIEIX was classified as a Foreign Large Growth fund with a 3 star rating.
    The corresponding category rank was: 5 Yr - 66; 10 Yr - 49; 15 Yr - 24.
    On 12/31/20, MIEIX was classified as a Foreign Large Blend fund with a 5 star rating.
    The corresponding category rank was: 5 Yr - 6; 10 Yr - 5; 15 Yr - 3.
    Although no material changes were made to the fund, it "improved" considerably!
  • edited June 6

    Oh, I am thinking I would fault them a bit. They know how their star system is used, and when it lacks nuance and context to this extent, and when star changes seem capricious, what's a consumer to do? (As an instructions writer, I know the answer: read deeper, read harder, RTFM. So why have stars in the first place? CU does a better job.)

    The M* star rating represents a mutual fund's risk-adjusted performance in its designated category.
    If a fund is "miscategorized", this rating may be of little value.
    Unfortunately, some investors overly emphasize star ratings when buying or selling mutual funds.
    John Rekenthaler from M* discusses the star rating in the following article.
    Link


  • msf
    edited June 6
    Here's an even more extensive M* piece on its categories, historically, how they're defined, and how funds are classified. It's a one hour(!) video and has a somewhat dubious transcription. (I'll probably watch the video and slides later.)
    https://www.morningstar.com/articles/754147/morningstar-categories-introduction-update-2016

    M*'s style box was created in 1996 (according to most sources). But until 2002 funds were rated according to broad categories, as Rekenthaler stated.

    All ways of benchmarking performance - using a large universe (e.g. US equity), using more precisely defined peers (style boxes), using an index blend that matches the fund's portfolio - have weaknesses. My intent was to highlight a weakness of comparing a fund with a "box" of peers: instability.

    In addition, the quality of the comparison degrades as one moves toward a boundary even without crossing it. This is something I have posted on a few times in the past year prior to the market rotating to value.

    Funds in an given style box, say blend, that tended toward value generally ranked more poorly than their peers that had a growth leaning. Normally this distortion effect isn't pronounced within a box. But because the gradient between growth and value was so large in the past couple of years one had to keep it in mind when looking at fund ratings.

    If you want stability, you can go back to M*'s old way of rating funds. Compare all US equity funds together. A fund can't drift out of this "box" because there's only one box. But then the possibility of ratings distortions within this one box become much larger. This is what Rekenthaler is calling "style effect".

    If you rate a fund against a hypothetical index benchmark blended to match the fund's portfolio (as I believe S&P is doing, or at least was doing years ago), you lose the sense of how well the manager is positioning the fund in its investment universe. What you get is just a measure of specific security selection, e.g. was the decision to invest solely in Coke rather than in the market mix of Coke and Pepsi a good one?

    If you like, fault M*'s choice of methodology (style boxes). Though each methodology has its weaknesses. The discontinuity in a fund's star rating is inherent in the style box methodology. M*'s quality of execution doesn't create that discontinuity, but rather determines when discontinuity manifests.
  • msf
    edited June 6


    I've had a similar experience with MIEIX.
    On 09/30/20, MIEIX was classified as a Foreign Large Growth fund with a 3 star rating.
    The corresponding category rank was: 5 Yr - 66; 10 Yr - 49; 15 Yr - 24.
    On 12/31/20, MIEIX was classified as a Foreign Large Blend fund with a 5 star rating.
    The corresponding category rank was: 5 Yr - 6; 10 Yr - 5; 15 Yr - 3.
    Although no material changes were made to the fund, it "improved" considerably!

    M* still posts the annual performance rankings of the fund based on the category it was in that year. I verified this by comparing the MIEIX rankings for 2018 and 2019 (when it was still classified as foreign large cap growth) with other foreign LCG funds that had nearly identical performances with MIEIX in those years.

    In 2018, MIEIX returned -10.66%. M* says that placed the fund at the 19th percentile. That's the same percentile as ARTIX was ranked, with its -10.86% return.

    In 2019, MIEIX returned 28.40%, only good enough for a 46th percentile ranking. That's the same percentile as TWEIX got with its 28.37% return.

    http://performance.morningstar.com/fund/performance-return.action?t=MIEIX
    http://performance.morningstar.com/fund/performance-return.action?t=ARTIX
    http://performance.morningstar.com/fund/performance-return.action?t=TWIEX

    However, on those same pages, annual performances are compared with the fund's current category, not the category the fund was in for each past year.
  • Thru the years I have reached the the point I ignore anything but the basic equity/fixed income ratio when comparing funds. Managers normally stay true to their culture and cultures are reflected in performance and risk metrics. Although I am in the minority on this point, I have seen too many anomalies to change my beliefs. Better to start your search with too many funds than omit good ones. My 2c.
  • edited June 9
    I find very little value anymore in the M* category criteria, or its star ratings. I have to look at performance charts, risk criteria, and a series of more specific fund characteristics, to find funds that fit a particular role I have for them in my portfolio categories. I use the M* information to evaluate and select funds for "my varying portfolio categories" which are different than M*, and I establish watchlists to monitor funds performance, but I pretty much ignore M* medal and star ratings. So, for example, I have a taxable account, which has a portfolio objective of being very conservative, to preserve principal, and to produce a total return of 2% to 3%, with very low volatility. I have 3 bond oef funds in my taxable account--a short term bond oef that M* has given 3 stars to, a HY corporate bond fund which M* has given one star to, and a nontraditional bond oef that has not received any stars because it is not 3 years old. On my watchlist for this taxable account, I maintain short term investment grade Munis and HY Munis, nontraditional bond oefs, short term bond oefs, HY corporate bond oefs, etc. which I have used in the past or would consider using in the future. I put funds on the interactive M* performance charts, to see how they performed in the past, during various market conditions, with a particular focus on performance in market corrections and recessions to get a picture of how well they preserved principal in downmarkets.

    I have very different bonds in my tax exempt IRAs, in which I take more risk, assume more volatility, and seek to produce higher total return than in my taxable account. Again, I ignore stars and medal information, in selecting those differing funds, from a wider array of M* categories.
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