No one likes to follow the herd, but almost everybody does. Following the herd feels safe… right up until the point where the herd leads you right off a cliff.

“The Morningstar Mirage,” a recent article from the Wall Street Journal, shows the dangers of herd-following in the mutual fund industry. Despite the repeated warning “past performance is not an indicator of future results,” investors continue to pile into funds that get a 5-star Morningstar rating, then find themselves disappointed when the funds fail to outperform.

Morningstar’s (MORN) success and growth is impressive. The firm’s ability to compete and take market share from other sell-side firms deserves respect. However, the growing dominance of the firm in the research business also leads to harmful inefficiencies and distortions in the market. Investors and advisors deserve other, independent sources of research that go beyond Morningstar’s backward-looking methodology.

The (Hidden) Limitations of Backward Looking Ratings

“History is strewn with examples where star fund managers have fallen to earth when their luck or skill deserted them, but the Morningstar ranking adjusted only slowly downwards, with Legg Mason’s Bill Miller perhaps being the most prominent example.”

Source: “Morningstar: A force to be reckoned with” By Stephen Foley.

Officially, Morningstar cautions investors against treating its star ratings as predictive. “We have always been very clear that it’s not intended to predict future performance,” the company wrote to the Wall Street Journal in response to their findings.

In practice, the media has identified several cases of the Morningstar and its officers touting the ratings as having predictive value. For example, Morningstar’s official Twitter account shared a quote from columnist Matt Levine saying “Morningstar is better at picking mutual funds than I would have expected.” The company conveniently ignored that he also said he expected Morningstar to have zero ability to pick mutual funds.