Assessing Performance of Morningstar's Star Rating System for Equity Investment

Abstract

Both institutional and individual investors have a vast array of advisory and ratings services to assist with security selection. One of the most prominent sources of stock ratings is Morningstar. This is the first large-scale study evaluating the performance of portfolios formed using Morningstar’s Star rating system for stocks. We evaluate the performance of portfolios formed using this rating system. Our results provide evidence that the Morningstar stock rating system allows an investor to build a portfolio with superior absolute and risk-adjusted returns over a long period of time. We show that a modest transaction cost will reduce, but not eliminate, these benefits. Overall, our results indicate that Morningstar ratings effectively discriminate between over- and undervalued stocks over the long term.

Keywords: Asset pricing, investment decisions, ratings and rating agencies, security analyst

JEL Classification: G240, G110, G120, G140