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 In this article we're going to discuss mutual fund rating systems. Of course the premier fund rating system is that published by Morningstar. But we're also going to discuss some of the problems an investor needs to be aware of when using a rating system and some of the alternatives to such systems.
Morningstar Mutual Fund Ratings
Many first time stock market investors are attracted to the qualities that mutual funds have to offer. But how does the investor know which mutual fund to pick? Well, perhaps the best known mutual fund ratings system comes from the company Morningstar Mutual Funds. This company has been in business for over 15 years and they specialize in the rating of mutual funds.
How the Star Rating System Works
The way the Morningstar Mutual Fund rating system works is based on a star system. Each fund is assigned a rating based on its performance versus an assigned risk peer group, and the fund can earn a rating anywhere from one to five stars. So that makes it pretty easy for the investor - just pick a mutual fund with a five star rating. If only it were that simple!
You see, 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% funds that provide the highest risk-adjusted return are given the prestigious five star rating.
Problems with Rating Systems
The problem with using this rating system is that the information used for each mutual fund is historical. 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 - because it is absolutely true.
Funds Rated on Past Performance
Just because a mutual fund performed well in the past does not mean it perform well in the future. In fact it might mean the fund will under-perform the market over the next several years.
That's because most mutual funds specialize in some manner. They do this to differentiate themselves from other fund offerings and this also provides the investor with options. For example, some mutual funds might specialize in creating portfolios of stocks in companies that make personal computer equipment.
For many years, these technology stocks pushed 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, these stocks funds have suffered for the last five to seven years. This is a clear example of the problem with the Morningstar rating system. And the smart investor realized that they should not blindly invest in mutual funds just because they were rated five stars.
This is not to say that the Morningstar rating system has no value. Past performance is certainly one indication of a well managed fund. And this rating system can certainly be used as a first filter when developing an overall investment strategy. For example, the rating system can be used as an introduction to prospective funds - but not 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 that money is going to be placed in a mutual fund then there is simply no substitute for conducting your own mutual fund research and you can even 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 a possible contrary indicator. For example, the investor might want to take a close 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?
Perhaps this is a good indicator of a sector to avoid in the immediate future.
So take that first step and look at how a mutual fund was rated, but just 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 and decide if their time has come to start moving ahead once again.
About the Author - Mutual Fund Rating
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