Research Article: The predictive ability of the expected utility-entropy based fund rating approach: A comparison investigation with Morningstar ratings in US

Date Published: April 19, 2019

Publisher: Public Library of Science

Author(s): Daniel Chiew, Judy Qiu, Sirimon Treepongkaruna, Jiping Yang, Chenxiao Shi, Petre Caraiani.


In this paper, we propose an alternative fund rating approach based on the Expected Utility-Entropy (EU-E) decision model, in which the measure of risk for a risky action was axiomatically developed by Luce et al. We examine the ability of this approach as an alternative fund rating approach for its ability to potentially mitigate the drawbacks of the risk measure used in Morningstar ratings, and investigate the ability of the EU-E model based and Morningstar ratings to predict mutual fund performance. Overall, we find that the risk measure used in both models plays a defining role in their ability to predict future fund performance, and that the EU-E model can effectively consider the behavioral decisions of an investor.

Partial Text

In recent history, mutual funds have been a dominant choice among investors with the industry growing rapidly over the past 30 years and with funds managed growing from $51 billion to over $15 trillion during the period of 1976 to 2015 [1], [2]. A key driving factor behind this growth can be attributed to the vast number of U.S. investors who attempt to beat the market each year coupled with the fact that mutual funds are viewed as an economical means for investors to diversify away unsystematic risk from their portfolios [3], [4]. Due to demand and growth in the industry, simple mutual fund rating tools have been developed to assist investors in making capital allocation decisions. The most prominent agencies include Morningstar, Lippers, and Zacks, which rank funds on a scale of 1 to 5 based on a fund’s calculated risk-adjusted return. Among these fund rating approaches, Morningstar ratings play a powerful role in the mutual fund industry and are viewed as a crucial metric for investors and fund managers [5], [6]. Thus, we focus on Morningstar ratings due to its prominence in the industry and its popularity in the evaluation of fund rating systems.

Mutual funds have become an increasingly dominant industry and asset class within financial markets in recent times. This paper examines one of the most widely renowned fund rating tools used in the industry, Morningstar ratings, with respect to a newly developed decision tool, the EU-E decision model, which is also used to rank financial assets. We explore the EU-E decision model as a possible alternative given its ability to potentially mitigate drawbacks of the risk measure used in Morningstar ratings.