Did Morningstar 'Fess Up Or Stumble?

Posted on August 17, 2010 at 2:09 PM PST by

We love to talk about how our method of investing is as exciting as watching paint dry. Sometimes, however, there is a little drama in our corner of the investment industry.

Russel Kinnel is Director of Mutual Fund Research for Morningstar, Inc. He released a study this week proving that mutual fund expenses are better at predicting a fund’s performance than Morningstar’s own 5-Star rating system. The story was widely reported because it was either an enormous oversight by Morningstar, or signaled an unexpected level of transparency by the firm.

Morningstar has profited by giving investors a winning “system” for buying mutual funds, similar to a Las Vegas card counting system that purports to beat the odds. Armed with their 5-Star rating system, investors believe they can buy the mutual funds that will outperform their benchmarks. For nearly 40 years, unbiased research from every corner of academia and industry has demonstrated that buying a portfolio of actively managed mutual funds is a “loser’s game” and that the Morningstar 5-Star rating system has little predictive value. Sadly, investors using it, have lost billions in retirement savings to unnecessary fees, taxes and under performance.

A portfolio of actively managed mutual funds is absolutely, without question, as bad for your wealth as smoking is for your health. In 1953, Dr. Ernst Wynder published a ground breaking study that established the health risks of cigarette smoking. In response, the leading tobacco manufacturers organized a massive counter-attack by forming the “Tobacco Institute Research Committee.” What sounded like an unbiased research organization was really a well-funded public relations ploy to calm down the public. For over 40 years, these manufacturers engaged in brutal litigation and campaigns to manipulate public opinion. Finally, industry insiders, Dr. Ian L. Uydess, Dr. William A. Farone and Jerome K. Rivers stepped up and testified against their employer Philip Morris which forever changed the industry.

For years, the mutual fund industry has waged a similar war against the passive index investment methods that we support. Like big tobacco, the mutual fund industry is large, profitable and immensely powerful. With large advertising budgets to influence “unbiased” mainstream media, they guide investors into bad investments. Morningstar has lined its pockets as a willing accomplice. Mr. Kinnel directs Morningstar’s research and has just announced that their rating system is a little bit better than bogus. In 50 years, will he be heralded as the first industry insider to finally tell the truth?