Three Essays on Mutual Fund Ratings

• Main Author: NG, Wee Seng
• Format: text
• Language: English
• Published: Institutional Knowledge at Singapore Management University 2013
• Subjects: mutual fund rating; corporate governance; stewardship grades; star ratings; persistence; mutual fund performance; Finance; Portfolio and Security Analysis
• Online Access: https://ink.library.smu.edu.sg/etd_coll/99; https://ink.library.smu.edu.sg/cgi/viewcontent.cgi?article=1098&context=etd_coll
• Institution: Singapore Management University

The incessant growth of the mutual fund industry has made the task of selecting mutual funds an increasingly challenging one. Unsophisticated investors turn to low-cost and readily available ratings to guide their investment decisions. Unsurprisingly, mutual fund ratings are hugely popular and influential. Anecdotal evidence and academic findings both suggest that investors gravitate towards top-rated funds. Rating is a double-edged sword. Although the use of rating simplifies the otherwise onerous job of evaluating mutual fund performance, it can lead to adverse consequences. Investors who invest only in top-rated funds are inadvertently assuming that good ratings indicate good future performance. However, some academic studies have called into question the predictive ability of mutual fund ratings. Furthermore, the efficacy of a rating depends on its persistence over time. The twin questions of whether ratings possess predictive power and whether ratings are persistent are the main catalysts for this study. This dissertation comprises three essays on mutual fund ratings. The first examines the relation between the Morningstar stewardship grade and various fund characteristics, such as size, expense ratio and fund manager’s tenure, that are known to be determinants of fund performance. With a data set spanning a period that covers both the recent financial crisis and the year in which a major revamp of the stewardship grade methodology was implemented, I further investigate whether financial crisis or methodology change could have any impact on the results. In the second essay, I model the Morningstar star rating as a continuous-time Markov process and use the estimated transition probabilities to study the rating dynamics for different types of mutual funds and for funds having different corporate governance ratings given by the Morningstar stewardship grades. Overall, persistence is weak. However, among funds with a good initial star rating, those with a good stewardship grade exhibit a higher probability of having their rating maintained or upgraded, and a lower probability of having their rating downgraded. Results of this kind provide credence to the notion that corporate governance matters in performance. In the third essay (co-authored with Jeremy Goh and Aurobindo Ghosh), we perform both ranked portfolio tests and predictive panel regressions to corroborate the dependence of risk-adjusted return (four-factor alpha or star rating) on corporate governance score (the stewardship grade) while controlling for fund-specific characteristics. We also propose the use of an objective corporate governance score based on principal component analysis in both static and dynamic fixed-effects regression models. Our results reveal that corporate governance scores do predict performance, thereby reaffirming the economic value of corporate governance to mutual fund investors.