Exclusive Interview: Prof. William Sharpe     Page 4

Star ratings do not measure how good a fund competes in its asset class, but instead give good marks for any fund that happens to be in an asset class in ascendance. The laws of reversion to the mean cause the star ratings to have little predictive value. The asset class that goes up precipitously often comes down to earth equally fast.

If there is little scientific basis to using Morningstar "stars" as ratings guides, then why are they so popular? "Morningstar ratings came out, took hold, and got into everybody's consciousness," he said. "Everybody looks at the star rating."

People need to understand how hard it is to predict superior performance, he emphasizes. "Past performance gives you a little edge," he said. "There is something there, but there is not a lot."

Generally, well-designed studies show little long-term performance consistency. For example, if growth funds do well over 6 years, a crude study may show that early leaders continue to outperform.

"Many fund families have so many funds they can always find funds with four or five stars after the fact," he said. Fund groups often deliberately seed dozens of small funds in anticipation that many will fail but some will show above average performance by luck if nothing else. "Pruning" by the industry of 3-4% of funds every year has a big effect on performance figures posted prominently in the financial press.

Sharpe takes issue more generally with the traditional method of establishing a target percentage of funding for each asset type and classifying funds according to that asset type.

"There are a number of arguments why this is not an efficient way to approach the problem."

"Many times with an active fund the standard descriptions don't tell you what you are getting in terms of asset exposures" he said. "You ought to know what you are getting."

"The other big problem is that if you are not using index funds, most funds are not a pure play," he said. Ensuring that you get the asset allocation you want can involve considerable extra work.

Will McClatchy

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