Gaming the System: The Impact of Morningstar Category Changes on Peer Rankings

Abstract

Portfolio managers change investment styles for various reasons. This is called “style drift.” Although the motivations behind changing styles vary and are difficult to quantify, it is possible to determine the relative impact on peer rankings and the subsequent impact on net fund flows for mutual funds that drift. If style drift was not motivated by relative peer group comparisons, we should expect to see little consistency in rankings for funds that drift or the types of funds that drift. This study suggests, however, that actively managed mutual funds that change Morningstar category tend to materially improve their relative performance rankings against their peers, were average or below-average funds in their previous category and become average or below-average funds in their new category, and that they move into categories that tend to underperform their previous category in the future. Funds that drift tend to improve their performance relative to their previous category by approximately 50 bps and, on average, receive increases in fund flows that are 10 times greater over the 12-month period following the change than for the 12 months preceding the change.