There is new statistical support for the industry axiom that nothing sells like a top Morningstar rating.
Funds with the two highest Morningstar ratings at the end of 1997 took in 72 percent - or about $160 billion - of new sales last year, according to Financial Research Corp., the Boston fund research and tracking firm. Indeed, Morningstar's top-rated funds, which carry five-star ratings, accounted for nearly 43 percent of fund sales last year, according to Financial Research, which issued a report on the subject in February.
Funds with one- and two-star ratings, Morningstar's lowest, last year suffered net redemptions of 2.6 percent and 8.2 percent respectively. Three-star funds had net sales of 4.7 percent.
The link between Morningstar ratings and sales is consistent with a trend which has influenced fund sales for several years, according to mutual fund executives and consultants.
"Investors and their advisers are following in lock-step" behind the Morningstar ratings, said Geoffrey H. Bobroff, a fund consultant. "There is a bloc of money that chases yesterday's performance."
That was good news for the Morningstar winners. Among the 25 best selling funds in 1998, 22 had a four- or five-star Morningstar rating, according to Financial Research. Those funds attracted nearly 40 percent of all new investments last year, said Ray Liberatore, an analyst at Financial Research.
Morningstar uses a five-star rating for those funds which rank in the top ten percent of their peer group as measured by risk-adjusted return. Funds in the next 22.5 percent of their peer group receive four stars.
Four- and five-star ratings increasingly will become "the primary selection criteria" for investors in coming years, Financial Research said.
That is because there will be fewer and fewer new funds as a result of market saturation, Liberatore said. After five-star funds, new funds - those with track records of less than three years - attracted the most sales in 1998. The roughly 3,300 new, or as Financial Resource called them "non-rated" funds, accounted for 34 percent of sales last year. Morningstar does not rate funds until they have a three-year track record.
As the new funds receive stars, and fewer new funds are added each year, sales will migrate even more toward funds with four- and five-star rankings. The trend will be further accelerated as the cost of distributing funds increases, Financial Research said.
All of this is good news for Morningstar and independent rating agencies, Bobroff said. When there is an abundance of products to chose from, investors or their advisers will look for endorsements by neutral third-parties to help guide them in making investment choices, Bobroff said.
The link between performance and sales also has an effect on mutual fund advertising. Fidelity Investments, for example, recently added performance figures to its national advertising campaign promoting its funds. The focus is typical for the industry.
Nevertheless, it has not been universally well received. Regulators have criticized the fund industry for its promotion of performance.
Barry Barbash, former director of the SEC's Division of Investment Management, told industry lawyers and compliance officials in a December, 1997 speech that mutual fund companies were creating a "performance cult" which jeopardized the industry's good will and prosperity in a down market.
"The industry must shift its focus away from a reliance on performance in both how it generates sales and how it manages assets if it wants to encourage fund shareholders to understand a basic truth about funds - that they are long-term investments," Barbash said.