Mutual Fund Star Ratings: Are They Useful?
Many people are somewhat familiar with mutual fund star ratings that were popularized by Morningstar’s 5 star rating system. For many busy working professionals, they often rely on the star ratings to pick funds in their 401K or other retirement accounts.
Unfortunately, the result of using the ratings system has been very mixed to say the least. Let’s look at the ratings and how they have been used in more details.
How does Morningstar rate mutual funds?
Based on Morningstar:
Morningstar rates mutual funds from one to five stars based on how well they’ve performed (after adjusting for risk and accounting for all sales charges) in comparison to similar funds. Within each Morningstar Category, the top 10% of funds receive five stars, the next 22.5% four stars, the middle 35% three stars, the next 22.5% two stars, and the bottom 10% receive one star. Funds are rated for up to three time periods–three-, five-, and 10 years–and these ratings are combined to produce an overall rating.
Aside from some minor details, the ratings are essentially based on risk adjusted returns or Sharpe ratios in the past.
The most popular Morningstar’s ratings are based on the prevailing three years performance. Morningstar has since introduced a another (less popular and comprehensive) mutual fund gold/silver ratings that they claim to be not only based on the past performance, but also on their human analysts’ subjective view. The methodology is subjective and has short history. It’s thus hard to evaluate.
There are many other fund rating systems such as Lipper, Zack’s, Standard and Poor etc. Most of these ratings are also based on past (risk-adjusted) returns. MyPlanIQ also rates mutual funds using last one year’s Sharpe ratio, among other minor factors.
Research results on the ratings
There have been many debates and studies on the usefulness of these star ratings. We recommend interested readers to read the recent Advisor Perspective article and some of the articles referenced in it.
The following summarizes the findings from these studies:
- Morningstar’s fund ratings (especially for funds rated highest as 5 or 4 star) has a weak predictive power on their subsequent (6 to 1 year) returns. To be precise, it means that 5 star funds on average perform slightly better than 4 star funds and so forth.
- However, the out performance is weak and can disappear soon. In fact, the Wall Street Journal study mentioned in that article contends that the five-star funds can’t maintain their top ratings over time.
- Another study by Advisor Perspectives found that the probability of a randomly selected five-star fund out performs a four-star fund is 50.6%, barely better than flipping a coin.
To some extent, long time readers of our newsletters shouldn’t be surprised by the above results. We have pointed out many times that there is no a reliable way to just pick some managers or investors and then ride on the funds forever.
How are ratings used in practice?
Even though many financial advisors understand the above research result and they seldom rely on the ratings to choose funds, many individual investors don’t have such intimate knowledge on the ratings. A typical misuse of the ratings is as follows:
- When one starts a 401k or other retirement account, she/he looks at the ratings of the funds available in the plan and chooses those with highest ratings.
- Every now and then (without regularity), this investor would look at the ratings, sometimes chooses to replace those that have not done well, sometimes chooses to ignore, hoping the funds will bounce back or thinking like ‘I’m investing in a long term and I don’t want to hop from one fund to another’, or there are other similar reasons behind hanging on those funds.
What we can see from the above typical process is that other than from the initial fund selection, the investor has behaved in a irregular or random way. This behavior certainly defeats the existence of the already weak prediction power of the ratings system.
In fact, the delusion caused by the fund ratings is much more harmful than its usefulness.
The ‘correct’ way to use fund ratings
For all of the fund ratings that are based on past performance, like it or not, using them as a guide to invest means you are essentially committing to a momentum type strategy. However, momentum based investing has to obey a rigid and regular rebalancing (or reexaminination) schedule: it’s actually quite sensitive to this process. In fact, in July 22, 2013: Tactical Asset Allocation: The Good, The Bad And The Ugly newsletter, we stated that:
Unlike buy and hold SAA, TAA is extremely sensitive to the rigorous implementation: if an investor does not follow the strategy for whatever reasons (such as the one above or just simply forget about it), it can be detrimental to follow back: say you miss the current buy and wait on sideline, will you get back into the strategy when markets are even higher? What happens if right after you start to follow it rigorously, it starts to lose (Murphy’s law)? Same can be said for selling.
This is exactly the issue for the Morningstar’s fund ratings: it’s a momentum based metric in disguise but for various reasons, Morningstar and other companies that feature such ratings don’t want to be seen as advocates to frequent buying and selling of mutual funds, let alone even with that, it only barely works.
Our view on these fund ratings is that they are only useful as the very first cut of perusal of funds. One can’t use them as the daily guide for fund selection. There is no such a comfort to just find a high ranked fund and then you are set. Investing is a process, not a one or several time deals.
To do so, you have to commit to a disciplined, intuitive and well researched strategy on a regular basis. In MyPlanIQ, our Strategic Asset Allocation (SAA) and Tactical Asset Allocation(TAA) and the fund selection algorithm are designed precisely for this purpose.
Stocks had gone through some volatile sessions in the Thanksgiving holiday period. Even though general US stock indexes like S&P 500 or Dow Jones 30 have broken records, there is a substantial under current. For example, there has been a considerable divergence among S&P 500 and the high flying semiconductor index SMH:
The likely cause of such a divergence is that investors are rotating out of high priced technology stocks to other sectors such as financials that are believed to have a greater benefit from the current tax reform bill. Many tech stocks such as Nvidia, after their parabolic rise, suffered from huge daily loss in the process. However, whether markets will continue without a correction after such a rotation is anyone’s guess. As always, we don’t want to read into these events too much and instead would simply stay the course and follow the selected strategies.
For more detailed asset trend scores, please refer to 360° Market Overview.
Now that the Trump administration has been in the office for more than half a year, it has stumbled and encountered many difficulties to implement its promised changes in terms of tax cuts, job stimulation and infrastructure spending. On the other hand, stocks continued to ascend, regardless of the progress. Looking ahead, however, we remain convinced that markets will experience more volatilities at some point when reality finally sets in.
In terms of investments, U.S. stock valuation is at a historically high level. It is thus not a good time to take excessive risk. However, we remain optimistic on U.S. economy in the long term and believe much better investment opportunities will arise in the future.
We again would like to stress for any new investor and new money, the best way to step into this kind of markets is through dollar cost average (DCA), i.e. invest and/or follow a model portfolio in several phases (such as 2 or 3 months) instead of the whole sum at one shot.
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