Fund managers often actively adjust their portfolios to achieve more favourable outcomes in Morningstar comparisons, according to researchers from Harvard and MIT. This strategy is said to lead to higher star ratings, enabling funds to justify higher fees, potentially at the expense of investor returns.
In the study Box Jumping: Portfolio Recompositions to Achieve Higher Morningstar Ratings, published in November, 2.300 investment funds were examined. Of these, 9 percent annually undergo a “box jump”, a restructuring that places them in a different Morningstar category.
The researchers claim to have evidence that some managers deliberately manipulate their portfolios to be compared against weaker peers in the peer group, thereby achieving higher rankings. While this could be coincidental, the researchers strongly dismiss that notion.
“This evidence casts significant doubt on the idea that box jumping occurs randomly.”
David Kim, Eric So, Lauren Cohen
Nearly a quarter of the funds analysed (within equity and US equity categories) and 37 percent of fund managers made at least one box jump between 1997 and 2007. These jumps often involve minor portfolio adjustments, but they do result in a shift to a new category with a different peer group.
Funds that transitioned to a new style box were, according to the research, twice as likely to see an improvement in their star rating as they were to experience a downgrade. “This evidence casts significant doubt on the idea that box jumping occurs randomly.”
Furthermore, the study shows that higher star ratings are typically reversed to their original level within three years.
Discussions with industry insiders suggest that this phenomenon is recognisable. On a background basis, experts say that fund managers are inclined to respond to the wrong incentives.
Increased inflows and higher fees
Funds that strategically adjust their positions to fit into new style boxes increase their management fees by an average of 5 percent, according to the research. Style box changes also frequently lead to a significant inflow of capital, with average assets under management increasing by 6.7 percent within twelve months of a box jump.
“Investors may be overly focused on Morningstar ratings when allocating capital, without distinguishing between upgrades driven by improved performance and those resulting from box jumping,” says doctoral researcher David Kim, who, together with Harvard professor Lauren Cohen and MIT professor Eric So, analysed data from Morningstar Direct.
According to Kim, funds achieving a five-star rating through box jumping would likely have received a lower rating without the jump. Although the study identified specific fund families and managers engaging in box jumping, the researchers declined to name them.
Lower returns
The researchers also conclude that box jumping leads to lower returns. They estimate an average decline of 21 basis points per quarter, amounting to 84 basis points in CAPM returns annually.
The lower returns, according to Cohen, So, and Kim, stem from fund managers stepping outside their areas of expertise due to the restructuring of their funds, as they invest in unfamiliar stock styles.
Morningstar remains sceptical
Morningstar, responding to the research, emphasises that its fund ratings are transparent and objective, with changes based solely on performance over three, five, and ten-year periods. Morningstar states it does not recognise the findings of the study in practice and sees no evidence to support them.
According to a spokesperson, the star rating is based on a fund’s historical, risk-adjusted return relative to its peers. “We do not assign star ratings based on style box classifications,” the spokesperson added. Morningstar also noted that funds are not assigned to peer groups solely based on their most recent portfolios.
“We base category assignments on a fund’s positions over the past three years,” the spokesperson explained. “The style box is a monthly snapshot, whereas the categories used for star ratings are based on a 36-month average.”
Because of this lag, fund managers, according to Morningstar, cannot reliably predict whether a box jump will result in a category or ratings change. Morningstar’s analysis, contrary to the claims of Harvard and MIT, shows that funds are more likely to be downgraded than upgraded after a category change.
“Although there are fluctuations in annual trends, the practice remains prevalent in recent years.”
David Kim, Doctoral researcher
Jeffrey Ptak, head of ratings at Morningstar, suggests that a 2002 change in the method used to assign funds to style boxes might explain some of the findings. He argues that the changes were not the result of deliberate actions by fund managers.
The researchers, however, argue that Morningstar may have misinterpreted parts of the study. “We also focus on categories based on three-year averages of snapshots, not just the style box snapshots themselves, even though we use that term in the study,” Kim explained.
The study covers the period from 1997 to 2007, but the researchers conclude that extending the period to 2022 reveals the same patterns. David Kim: “While there are fluctuations in annual trends, the practice remains strongly evident in recent years.”