Mutual Fund Rating

In this article, we're going to cover the topic of mutual fund ratings.  This discussion will include the premier fund rating system as published by Morningstar.  We're also going to discuss some of the problems an investor needs to be aware of when using a rating system, as well as the alternatives to such systems.

Morningstar Mutual Fund Ratings

Many first time stock market investors are attracted to the features mutual funds have to offer.  But how does the investor know which mutual fund to pick?  Perhaps the best known mutual fund ratings system comes from the company Morningstar Mutual Funds. This company has been in business for over 25 years, and they specialize in the performance rating of mutual funds.

How the Star Rating System Works

The Morningstar Mutual Fund rating system is base on a star ranking classification.  Each fund is assigned a rating of its performance versus an assigned risk peer group.  The fund can earn a rating from one to five stars.  The system is meant to be intuitive for the investor.  Simply pick a mutual fund with a five star rating.  If picking mutual funds were that simple, we'd all be rich.

Unfortunately, the Morningstar rating system is based on historical performance.  The company calculates the star rating by subtracting the mutual fund's risk score from its return score, and plots those points on a curve.  The top 10% of funds that provide the highest risk-adjusted return are given the prestigious five star rating.

Problems with Rating Systems

The fundamental problem with using this rating system is the information used for each mutual fund is based on historical performance.  If you've ever read a mutual fund's prospectus, and you should, you've read that catchy little disclaimer that "past performance is not an indication of future performance."  The Securities and Exchange Commission makes mutual funds put that disclaimer on a prospectus for a good reason.  It is absolutely true.

Funds Rated on Past Performance

Just because a mutual fund performed well in the past does not mean it will perform well in the future.  In fact, it might mean the fund will under-perform the market over the next several years.

Most mutual funds specialize in some manner.  They do this to differentiate themselves from other fund offerings, and this approach also provides the investor with options.  For example, some mutual funds might specialize in creating portfolios of stocks consisting of companies that make personal computer equipment.

For many years, the price of these technology stocks accelerated well ahead of the market.  The Morningstar ratings for many of these technology-focused mutual funds would have been five stars.  But as we all know, the technology stock funds suffered for the next five to seven years.  This is a clear example of the problem with the Morningstar rating system.  The smart investor realizes they should not blindly invest in mutual funds just because they carry a five star rating.

This is not to say that the Morningstar rating system has no value.  Past performance is certainly one indication of a well-managed fund.  This rating system can also be used as a primary filter when developing an overall investment strategy.  For example, the rating system can be used as an introduction to prospective funds.  However, the rating would not be the deciding factor, or the only factor, to use when selecting and / or researching a mutual fund.

Alternate Approaches to Rate Mutual Funds

Investing one's hard earned money should never be about short cuts.  If money is going to be placed in a mutual fund, then there is no substitute for conducting your own mutual fund research.   It's easy enough to develop your own mutual fund rating system based on information such as:

• The mutual fund's fit with your financial objective
• The historical returns of the mutual fund
• Measures of the mutual fund's volatility such as bear market rank
• Mutual fund fees such as front-loads, management fees, and expense ratios

In fact, many of these same concepts are discussed in our four part series on buying mutual funds.

Mutual Fund Ratings as Contrary Indicators

Another way to use these mutual fund ratings is to consider them as a possible contrary indicator.  For example, the investor might want to take a closer look at all of the five star funds and try to decipher a pattern:

• Did these funds contain large capitalization stocks?
• Did they provide portfolios of an industrial sector that may have experienced a run up in prices?

After considering these factors, the investor or analyst might decide to avoid a certain sector of the economy in the immediate future.

It's important to take that first step.  Examine the rating of a mutual fund, but keep in mind that an over-performing fund is very likely to slow down in the future.  Finally, as an alternative strategy, you might even want to take a closer look at quality funds that have under-performed the market.  Careful research might conclude that the time has come for another sector of the economy to start moving ahead once again.

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