Are mutual fund ratings useful? Evidence on ratings non-persistence and fund closure risk

Objectives: Retail investors use information provided by mutual fund rating agencies to make investment decisions. Mutual fund ratings, however, typically reflect only past fund performance which raises the question whether or not these ratings are a useful source of information for retail investors with respect to future fund performance. To answer this question we examine the mutual fund rating migration and whether mutual fund ratings contain information with respect to the closure risk of mutual funds. In this context, strong migration, i.e. low levels of ratings persistence, would indicate that ratings were no useful source of information for retail investors.

Data/Methods: We use a dataset that includes more than 2,000 mutual equity funds with their corresponding Morningstar mutual fund rating (five-star to one-star ratings) from 2005 to 2012. We differentiate between buy-and-hold investment strategies and dynamic investment strategies. To assess the information content of mutual fund ratings for buy-and-hold investment strategies, we determine the rating migration based on the first and the last mutual fund rating over two-, four-, six-, and eight-year horizons. With respect to dynamic investment strategies, we calculate the number of rating changes per fund during these time horizons on a monthly basis.

Results: We find that mutual fund rating persistence is low or even non-existent in particular over longer time periods. Only for lower-rated funds, the rating appears to indicate higher risk of fund closure. Thus, the fund rating is no useful predictor for a buy-and-hold-strategy. In addition, mutual funds face a large number of up to 38 monthly rating changes over our longest time horizon of eight years. Besides high costs resulting from transaction fees, investors that follow a dynamic investment strategy would also not benefit from using fund ratings as investment guideline. Overall, due to the extensive rating migration and the high number of monthly rating changes, we conclude that mutual fund ratings barely contain any useful information for retail investors.