Irwin Schrödinger used his cat to explain a peculiar fact of quantum physics known as the “superposition of states.” In his thought experiment, using the kind of mathematics you only see in nightmares, Schrödinger proved the cat can be both alive and dead at the same time. Weird, right?

I mention this as a way to introduce the controversy of the “superposition of states” of Morningstar's Star Ratings. Should they be used as a predictive reference, or should they be viewed solely as a historical evaluation?

A 1996 academic study showed Morningstar's Star Ratings had no predictive value, and Morningstar concurred. Advisors pointed to this study to support their views. But Morningstar has since changed its algorithm, hurling the study into irrelevancy.

Morningstar's tune has remained remarkably consistent. In the Dec. 6, 1996, issue of Morningstar Mutual Funds, Amy C. Arnott said, “Many commentators insist on treating the star rating as a predictive measure or a short-term trading signal. The rating, which is clearly labeled as a historical profile, does neither.”

Subsequent to their algorithm change in 2002, Christine Benz in her 2005 book Morningstar's Guide to Mutual Funds, said, “…the star rating is based on how the fund did in the past. It won't predict short-term winners.”

Finally, Don Phillips, in 2010's “Star Wars, the Sequel,” said “The Morningstar Rating for funds is a grade on past performance. Period. No one at Morningstar ever claimed that the stars have predictive power.”

But now Morningstar's tune might be evolving.

A spokesman for Morningstar told me, “…after we changed our methodology in 2002,… we did find some moderate predictive value.”

Edwin Choi, however, in his article, “Morningstar Ratings: Useful or Useless?” analyzed a 2010 Morningstar study. He concluded the study showed the expense ratio was a better predictor of outcomes than the Morningstar Rating.

Two Pace University professors ran an independent study and reported, “…we find widespread support for the notion that the new Morningstar rating system can predict future performance…”

Yet Morningstar's own licensing agreement, after sketching out how the Star Rating is calculated, states “Past performance is no guarantee of future results.”

When asked if it believes the stars are predictive, a Morningstar spokesman said: “That depends on your interpretation of the word 'predictive' – [does it mean] guaranteed or associated with good outcomes?” Morningstar's Star Rating doesn't 'guarantee' any results. We believe the star ratings are associated with good outcomes, but we've always said we don't want people buying funds simply because they have 5 stars.

So do they or don't they? In Morningstar's eyes, the answer appears to be an unequivocal, “Yes.”

Schrödinger would be proud.

Instant Insights /

The truth about cats and Morningstar ratings

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