www.sciedupress.com/afr Accounting and Finance Research Vol. 5, No. 1; 2016 Published by Sciedu Press 202 ISSN 1927-5986 E-ISSN 1927-5994 Mutual Fund Ratings and Efficiency: An Examination of the Relationship Mahendra Raj 1 & Md Hamid Uddin 2 1 Institute of Management Technology Dubai, Dubai, UAE 2 College of Business Administration, University of Sharjah, Sharjah, UAE Correspondence: Dr. Mahendra Raj, Professor of Finance, Institute of Management Technology, Dubai, DIAC, Dubai, UAE. Received: November 19, 2015 Accepted: January 20, 2016 Online Published: January 28, 2016 doi:10.5430/afr.v5n1p202 URL: http://dx.doi.org/10.5430/afr.v5n1p202 Abstract Morning Star is a rating agency that rates mutual funds based on past performance. The best performing funds are rated 5* while the lowest performing ones are rated 1*. Investors rely heavily on these ratings for making their investment decision. Funds with high rating tend to attract millions of dollars more than those rated lower. The highly rated funds also charge higher management fees as compared to the lower rated funds. Very few studies have examined whether the higher ratings and fees are justified by better performance. In this paper we use a Data Envelopment Based measure of efficiency to examine whether the funds rated 5* are more efficient than funds that are rated 3* by Morning Star ratings. We use returns as the sole output and standard deviation and expense ratio as the two inputs. The results of the study indicate that by and large the Morning Star 5* funds are more efficient than the 3* funds. Another significant find is that small cap funds are generally more efficient than large caps. This implies that even within a particular rating category small funds may be a better investment. The findings of the paper are significant as they provide evidence that ratings are a useful tool for investors in the selection of funds. Keywords: Mutual funds, Morning Star, DEA, Rating, Efficiency 1. Introduction Mutual funds have found their way into the lives of millions of people across the world either as part of their investments or as part of their pension pot. The choice of funds available to the investors is large and their decisions to invest in a particular fund are largely influenced by the ranking/rating of the fund. Companies that constantly evaluate mutual fund performance give these rankings/ratings. For the average investor planning to take advantage of a mutual fund as a "one-stop investment", it is imperative that a performance measure not only gives an accurate measure of the fund's historical performance, but also an indication of its future performance. In America, Morningstar Inc. is the industry leader whose star-ratings greatly influence the investor behaviour. However, earlier studies have revealed that the majority of mutual funds in the US did not perform any better than the indices against which they have been measured. A ranking system like Morningstar derives its ratings by classifying funds on their risk adjusted return performance. Other measures of fund performance include Sharpe index (Sharpe, 1966), Treynor index (Treynor, 1965) and Jensen’s alpha (Jensen, 1968). Theses indices and rating system lose out since they do not have a specific benchmark and ignore market timing and costs. As a result the performance measurement can be subjective. Grossman (1976) and Elton et al. (1993) support the inclusion of transaction costs in appraising the performance of funds. Sharpe (1998) argues that neither Morningstar’s measure nor the excess-return Sharpe ratio is an efficient tool for choosing mutual funds within peer groups for a multi-fund portfolio. The investor has access to information regarding performance of the funds and the various time-horizons over which the performance was achieved. However, the investor is typically left to his own intuition to decide which past performance is the most meaningful in terms of predicting the future performance. The ratings awarded to funds can be subjective and can lead to mis-identification of high performing funds. For example, in case of Morningstar’s ranking system long-term performance is given more weighting than short-term performance, as a result a poor performing fund might still be highly rated due to strong long-term performance.