Mutual Fund Ratings and Efficiency: An Examination of the Relationship

Abstract

Morning Star is a rating agency that rates mutual funds based on past performance. The best performing funds are rated 5* while the lowest performing ones are rated 1*. Investors rely heavily on these ratings for making their investment decision. Funds with high rating tend to attract millions of dollars more than those rated lower. The highly rated funds also charge higher management fees as compared to the lower rated funds. Very few studies have examined whether the higher ratings and fees are justified by better performance. In this paper we use a Data Envelopment Based measure of efficiency to examine whether the funds rated 5* are more efficient than funds that are rated 3* by Morning Star ratings. We use returns as the sole output and standard deviation and expense ratio as the two inputs. The results of the study indicate that by and large the Morning Star 5* funds are more efficient than the 3* funds. Another significant find is that small cap funds are generally more efficient than large caps. This implies that even within a particular rating category small funds may be a better investment. The findings of the paper are significant as they provide evidence that ratings are a useful tool for investors in the selection of funds.