By Nathan Carmany
The third quarter is coming to a close in a few weeks and soon people will start asking where the year has gone. Considering the recent market volatility, people will start wondering where their portfolio returns have gone or where will they come from to finish the year strong. When investors start this cycle, Morningstar ratings are frequently used to help identify “opportunities” when a fund gets an upgrade to a four of five stars or to avoid pitfalls if a downgrade happens to one or two stars. Does the star rating give the investor anything meaningful to make an informed decision?
How are Morningstar ratings figured?
Start by examining language directly from Morningstar: “The Morningstar RatingTM for funds methodology rates funds based on an enhanced Morningstar Risk-Adjusted Return measure, which also accounts for the effects of all sales charges, loads, or redemption fees. Funds are ranked by their Morningstar Risk-Adjusted Return scores and stars are assigned using the following scale:”
Examine the table above, noting that a new fund of fewer than five years of age will have an overall rating of the three-year rating. As the fund gets older, the weighting changes for the overall star rating. If a novice investor is reviewing his 401k options, for example, and looking at the overall star rating with a 12 year old and say a three year old fund, the same overall star rating will not be an apple to apples comparison. The older fund will have likely gone through a market cycle or two while the younger fund may have luckily entered the marketplace at the right time.
Vanguard completed a study in 2010 asking two questions. 1. Why do index funds tend to receive average ratings? 2. Do ratings provide any actionable information? Even though Vanguard is noted for low-cost index funds, the study did confirm the important point that cost does matter, but it also highlights other important factors (1.)
The study notes the probability of excess returns with the following graph. Note the one-star funds have a seven percent better probability of generating excess returns than the five-star funds on average.
Wall Street Journal Investigates
The Wall Street Journal produced an article in the 9/7/2014 publication titled “Mutual Fund’s Five Star Curse.” Most top performing funds lose their five-star rating. In fact, only 15% maintained the highest rating over the ten-year period examined by the study. Other noteworthy points include:
- Watch for growing pains in the fund. As a fund performs better and the rating increases, funds may have a large influx of cash. The manager may become paralyzed on where to invest the funds.
- Keep it simple. The article highlights the easy articulation of the DFA Core Equity 1 fund.
- Get the balance right. Highly rated funds that maintain a balance of stocks and bonds tend to maintain a consistent Morningstar rating.
When your 401k statement comes, be mindful of how you evaluate or choose your mutual fund investments. The Morningstar rating is not a buy or sell recommendation. Talk to your advisor or use an online assessment tool to help you develop a holistic investment plan.
Please remember Morningstar even notes “(The) Ratings are objective, based entirely on a mathematical evaluation of past performance. They’re a useful tool for identifying funds worthy of further research, but shouldn’t be considered buy or sell signals (3.)”