In this article, we're going to cover the topic of mutual fund ratings. This discussion will include an explanation of the premier fund rating system as published by Morningstar. We're also going to discuss some of the problems investors need to be aware of when using a rating system, as well as the available alternatives.
Investors new to the stock market are often attracted to the features mutual funds have to offer. The challenge then becomes determining which funds to pick. Perhaps the best known ratings system comes from the company Morningstar, which has been in business for over 30 years, specializing in the performance rating of mutual funds.
The Morningstar rating system is based 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: Pick a mutual fund with a five-star rating. If choosing a mutual fund were that simple, everyone would be rich.
Unfortunately, the Morningstar system is based on historical performance. The company calculates the star rating by subtracting the 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.
The fundamental problem with using these types of rating systems is the information is based on historical performance. Ironically, every mutual fund prospectus published has a disclaimer that reads "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.
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 offerings, and this approach also provides the investor with options. For example, a fund 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 history reveals, 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. Smart investors realize they should not blindly purchase shares of a mutual fund just because they carry a five-star rating.
This is not to say 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.
Investing one's hard earned money should never be about short cuts. If money is going to be placed in a mutual fund, there is no substitute for conducting research ahead of time. It's easy enough to develop a comprehensive rating system based on information such as:
Many of these same concepts are discussed in our four-part series on buying mutual funds.
Another way to use 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:
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, take a closer look at quality funds that have under-performed the market. Careful research might conclude the time has come for another sector of the economy to start moving ahead once again.
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