Exclusive Interview: Prof. William Sharpe      Page 3

Some may find it surprising that he is a partial investor in active funds. "I am not religious about putting all your money in index funds," he said. Ultimately the benefits of index funds are not to be assumed. They must be proven by rigorous study.

Curiously, the theory of efficient markets insists that the more competition there is for top returns the more tenaciously the theory will hold. If everyone fled to index funds no one would be calling the bluff of overheated sectors.

"We have to have active investors or the markets will go crazy," he said.

In an article for the July/August 1998 Financial Analysts Journal, Sharpe examined in depth the various metrics of Morningstar, Inc. for analyzing mutual funds. He found some of the more popular ratings of dubious value.

Sharpe's landmark study Morningstar's Risk-adjusted Ratings calls into question the practical benefit of some, but certainly not all, of the more popular metrics of the world's best known mutual fund research group.

"If you have to use one, use the category ratings because the comparisons are somewhat more homogeneous," Sharpe said. "You have to compare a growth stock manager's performance with a growth index and a value manager with a value index." Morningstar highlights its category ratings as well, but marketers for mutual funds generally ignore them in favor of the imagery of stars.

In principle information is always beneficial to the markets, but when large numbers of investors are basing decisions on their retirement income exclusively on ratings such as Morningstar "stars", there is something wrong with investor education. Although Morningstar has clearly stated that stars are not clear indicators of future performance, investors continue to latch on to the appealing rankings.
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