Fund rating system not fool-proof
07/25/2010 0 comments
John Norris, an independent economist and financial adviser answered the following question
Our 401K plan at work has some 2 and 3 Star funds in the menu of available options. Shouldn't it be only 4 and 5 Star funds? If so, are our employer and the plan provider doing their job?
His answer:
Morningstar does a decent job compiling data on mutual funds, and presenting it in a user friendly format. So much so, their proprietary rating system has become the industry standard. Discussions on any mutual fund will eventually focus on the Morningstar Rating, usually within the first minute or so.
However, just because it is most widely accepted mutual fund ratings organization doesn't mean Morningstar, or its methodology, is infallible. It isn't.
Morningstar appears to start with a very performance sensitive mathematical approach. The more a fund's return deviates from its average, the riskier Morningstar perceives it to be. Armed with this risk and return, Morningstar determines whether a particular fund adequately compensates investors for the amount of risk they take.
Let's face it. There are a lot of funds out there. It would be virtually impossible for Morningstar to scour every prospectus and analyze every investment in every fund. It would be impractical to spend umpteen hours understanding each portfolio manager's investment strategy and discipline. After all, the company doesn't make any representation their system is fool-proof, and it doesn't have to be. It just has to be better than what you can cook up on your own.
In other words, the Morningstar Rating is a decent guide, but it shouldn't be the only factor in determining a fund's appropriateness.
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