Star Ratings and the Incentives of Mutual Funds

Abstract

We propose a theory of reputation to explain how investors rationally respond to mutual fund star ratings. A fund's performance is determined by its information advantage, which can be acquired but decays stochastically. Investors form beliefs about whether the fund is informed based on its past performance. We refer to such beliefs as fund reputation, which determines fund flows. As performance changes continuously, equilibrium fund reputation may take discrete values only and thus can be labeled with stars. Star upgrades thus imply reputation jumps, leading to discrete increases in flows and expected performance, although stars do not provide new information.MUTUAL FUND FLOWS ARE CLOSELY associated with fund star ratings. Analyzing Morningstar ratings, Del Guercio and Tkac (2008) show that when a fund is upgraded from the four-star group to the five-star group, on average, it observes positive abnormal flows of 53% to 61%. 1 Reuter and Zitzewitz (2015) further find that bottom five-star funds tend to receive significantly more

Tracking error vs tracking difference: Does it matter?

“…Finally, for the scholarship of finance, these results suggest that future studies should utilise both metrics and compare the findings when evaluating the tracking performance of funds, especially as this continues to be a well-researched area given the continued growth of passive investments. Our findings also contribute to the growing literature on the role of fund fact sheets in investment decisions and the importance of disclosing full information to investors (Beshears et al, 2011;Ben-David et al, 2019;Darendeli, 2019;deHaan et al, 2019;Huang et al, 2020).…”

“…In light of our findings, we make important recommendations as to changes that should be made with respect to the measurement and reporting of tracking performance. Our study contributes to the growing literature on the role of fund fact sheets in investor decisions and the importance of disclosing full information to investors (Beshears et al, 2011;Ben-David et al, 2019;Darendeli, 2019;deHaan et al, 2019;Huang et al, 2020) and the extant literature on the tracking performance of passive funds (Aber et al, 2009;Rompotis, 2009;Strydom et al, 2015).…”

Coarse Grades: Informing the Public by Withholding Information

“…Lemma 1(iii) tells us that it arises for all decreasing f , and Lemma 1(iv) tells us it can arise generally with unimodal distributions. Figure 5, panel A shows a Beta (2,3) distribution where the pass cutoff is in the region of decreasing f so that one might expect the same tradeoff. Since f (0) = f (1) = 0 , by Lemma 1(iv) the gap is increasing in p after some internal minimum, and the same tradeoff does indeed arise.…”

“…Indeed, most such websites provide summary measures containing exact numeric scores, fine categorizations, or some combination thereof, and offer immediate access to detailed review information. 3 We also expect that coarseness is less likely for mandatory labels provided by government agencies. Since they can force firms to provide information about their products, there is no need to encourage participation by clouding the truth.…”

“…Figure 6uses two Beta(3,6) distributions, one with support on [0, 1] and the other renormalized with support on [1/2, 3/2] . The shown cutoffs p L and p H are optimal for c = 1/3 .…”