The Effect of Morningstar Rating Changes on Mutual Fund Performance and Strategy

Abstract: The purpose of this thesis is to examine if and how changes in Morningstar ratings affect the performance and investment strategy of mutual funds. This study uses a sample of 223 U.S. stock mutual funds that during the period January 2002 – February 2009 had at least one isolated Morningstar rating change over a two year period. The effect of Morningstar rating changes is analyzed as an event study. The benchmark for evaluating fund performance and investment strategy is the Carhart (1997) four factor model. It is found that there is a significant change in mutual fund total net assets following a Morningstar rating change, but the effects on performance and investment strategy are less pronounced. In the year following a rating change, there is an improvement in performance for upgraded funds and to a lesser extent a deterioration in performance for downgraded funds. This thesis finds that fund managers receiving a higher rating tend to reduce the risk of their portfolios in the year following a rating change while the effect on managers of downgraded funds is more ambiguous.