'Ratings' aren't much better than 'hot tips'

A "hot stock tip" can be a bum steer as easily as it can be a big winner, but most investors would suggest that a solid "investment ranking" should never lead them astray.

The problem is that few people understand what goes into rankings and ratings of investments, and yet they rely on those measures as if they were guaranteed recommendations.

For proof, there's a fascinating case involving Morningstar Inc., and the perception of the company's powerful ratings system. While the case involves a hedge fund - and Morningstar's hedge-fund research database is a completely different animal from its traditional fund research - the underlying concepts should get investors everywhere to thinking about the information they rely on to make decisions.

Morningstar recently lost a bid to dismiss a lawsuit that alleges that the firm played a part in promoting a Ponzi scheme by giving a fraudulent hedge fund a five-star rating late in 2009.

Life's Good Stabl Mortgage Fund was run by Robert Stinson, who told investors he would generate double-digit returns - as much as 16 percent annually - but who instead was absconding with investor money. While the numbers covering the scope of Stinson's fraud vary slightly, the total rip-off was about $17 million taken from roughly 150 hedge fund investors.

In April, a court-appointed receiver representing Stinson's victims filed a lawsuit against Morningstar, alleging that the Chicago-based research firm aided and abetted Stinson's scheme by giving his fund a good rating.

While it looks like a frivolous suit targeting a deep pocket because so few of Stinson's stolen monies have been recovered - in fact, three individual investors ripped off by Stinson filed a virtually identical suit basically seeking to put the blame for their misstep on someone else - Morningstar has not yet been able to wriggle off the hook.

Hedge funds are unregulated investment pools, and Morningstar's ratings of them are completely voluntary. Hedge-fund managers who want to be part of the database submit their return information to Morningstar; if they don't want to participate, they're never in the database, and if they stop submitting information, they are marked as inactive, a telltale sign that performance has suffered to where management doesn't want to discuss it..

That's a far cry from the firm's famous ratings of traditional mutual funds, where every fund is examined whether they want to participate or not, and where portfolio data comes from official documents that the funds must file with regulators.

The receiver in the Stinson case acknowledges that Life's Good Stabl Mortgage submitted false data to Morningstar , intent on receiving a rating. Obviously, Stinson didn't tell Morningstar what he was doing, but the receiver says in the suit that Morningstar "knew, or was reckless and/or willfully blind in not knowing that Stinson was breaching his fiduciary duties and committing fraud."

Morningstar also bears responsibility, in the eyes of the receiver, because its five-star rating would make it that a "reasonable investor" would "consider the misrepresented facts important" in making a decision.

Here's where the suit is off base - even if it survived the latest dismissal effort - because Morningstar has no responsibility to uncover fraud; that's not what it says it does, nor has it ever made that claim at any level. Read the fine-print disclosures - and the people using the company's hedge-fund database should be sophisticated enough to do that - and Morningstar makes it clear that its hedge-fund ratings are based on self-reported numbers, and that Morningstar bases its risk-adjusted return information entirely on information it is given.

It takes that data at face value, which works in traditional mutual funds typically, but can be off more easily in the unregulated hedge funds.

"Our ratings are meant to be a starting point, not what you base the entire decision on," said Morningstar's Alexa Auerbach.

Just because someone uses ratings incorrectly - and expects too much from them as a result - doesn't mean they can't sue someone for not preventing their blunder.

Ultimately, however, I think this case against Morningstar goes away, with the receiver and investors getting nothing from the company.

The rest of the investing public, however, gets a good lesson, if they care to look.

Ratings and rankings - no matter the company behind them - always will be inherently flawed.

They measure the past, though the audience believes they are predictive. They are built to act as a filter, to winnow thousands of choices down to an appropriate few, at which point an investor's judgment, style and intuition should take over.

Instead, most investors just keep right on filtering until they get a name that they think must be the best of the bunch.

"At some point, people - or maybe it was their advisors - became guilty of accepting rankings as something more than they really are," said industry consultant Geoff Bobroff of East Greenwich, R.I. "

That's dangerous because if the investment blows up, the ratings agency will not be the one on the hook for the losses. In the end, this case against Morningstar will prove that again.

Remember that the next time you look at a rating and think "This means it's a good buy."

Chuck Jaffe is senior columnist for MarketWatch. He can be reached at cjaffe@marketwatch.com.


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