Investor Discussions - Mutual Fund Rating Systems
Wealth & Pension Services Group
William Kring, CFP®, AIF - Chief Investment Officer
09/19/2014
Investors are always on the lookout for an edge when it comes to putting money to work in the markets. Unfortunately, many investors fail to conduct proper due diligence and instead rely too heavily on recent performance and third party rating systems such as Morningstar’s star rating system. This behavior may lead to unexpected portfolio results.
A History Lesson
The Morningstar Rating System debuted in 1985 as a way for investors to compare risk-adjusted returns among similar mutual fund strategies. Since its inception the system has continued to evolve and currently accounts for factors such as downside risk and the specific treatment of fund expenses within differing share classes. It also puts more emphasis on longer-term returns associated with skill and less focus on short term outperformance which may be attributed to luck. Overall, Morningstar’s Rating System provides investors an easy way to evaluate the past risk-adjusted performance of individual funds.
Maintaining One’s Star Power is Difficult
Unfortunately, past performance is not necessarily an indicator of future returns. Although the rating system puts heavier emphasis on longer term performance and ranks skillful managers higher, it doesn’t offer much in the way of predictive power for the future. For example, a study done by Vanguard showed that from June 30, 1992, through August 31, 2009, investors had a 50% chance or less of choosing a fund that subsequently outperformed its benchmark over the subsequent 36-month period, regardless of its rating at the beginning of the period.
Likewise, investors often fail to realize that even good managers can go through tough times and exhibit poor performance. Morningstar reported that from July 2004 to July 2014, out of the 458 funds that started as 5-star rated funds, only 58 or 14% remained 5-star rated at the end of the period. In addition, Vanguard found that on average most funds did not retain their current rating over the following 12 months, as seen in this chart. Specifically, only 53% of 3-star rated funds retained their rating over the next 12 months. This clearly illustrates that choosing a fund that will remain 4 or 5-star rated over the long-term is very difficult and other methods should be employed.
Stick to the Details
Rather than focusing solely on past returns, investors should perform more qualitative research such as better understanding exactly what a fund’s investment strategy entails. For example, two equity managers might be labeled as Large Cap Core, but one might manage with a growth bias and the other is more value oriented. Additionally, one fund manager might only invest in 30-40 holdings, while the other typically holds 400+. These examples illustrate factors that the Morningstar Rating System doesn’t account for and highlights simple, but important, characteristics that are often overlooked by novice investors.
Lastly, investors need to make sure they know exactly who is managing their funds. Individuals often put money with a fund because of their familiarity with the fund’s name, but fail to realize that the previous fund manager has since left the firm. Thus, the person who helped earn the 4 or 5-star rating is no longer the individual managing the strategy. On the flipside, a 1-star fund may hire a new manager who previously ran a 5-star fund. The fund will unfortunately have a poor rating due to its past performance, but now has the potential to perform better due to the new manager’s skillset. An investor who simply uses the Morningstar Rating System would likely overlook this potential difference.
All the examples provided are intended to help emphasize why it’s important to perform proper due diligence and not rely solely on rating systems. Although the Morningstar Rating System may be a good tool for starting a search, it’s critical for investors to take their research a step further and truly understand where they are putting their money.
Source: Morningstar, Vanguard, Wall Street Journal