On the Role of Risk in the Morningstar Rating for Mutual Funds

Abstract

In the mutual funds industry the rating process is very important, and Morningstar is surely the most influential international rating agency.

In this work we consider the problem of evaluating if the risk component is adequately accounted for in the Morningstar rating. To face this problem we compare the ratings produced giving different weights to the risk component.

The focus of the analysis is on testing the hypothesis that two similar rating procedures with different risk parameters (or, in statistical terms, two raters) are equivalent. To that end, first the notion of beta-equivalence is introduced and then a Monte Carlo test for the hypothesis of beta-equivalence is described.

Finally, to answer the question on the role of risk in the Morningstar rating, we analyze 1763 monthly return time series of US mutual funds. Results show that the current Morningstar classification, based on a risk-adjusted measure, only marginally accounts for risk and that if we want that risk really matters, the risk parameter should be increased.

Keywords: Rater agreement, beta-equivalence, mutual funds, Morningstar rating

JEL Classification: C10, G10, G20