Why You Shouldn’t Be Fooled by Mutual Fund Ratings

When we look for the best restaurant, we usually go by the ratings. Even when patients look for the “best” doctor, they often go by the ratings. So it makes sense that investors would look to ratings when choosing a mutual fund to invest in.

But therein lies the problem.

Mutual fund ratings don’t work. In fact, going by higher ratings may lead you to worse investment returns.

But how? And why?

Well, that is what we are going to discuss right here!

What are mutual fund ratings?

The most famous and prevalent mutual fund rating system is from Morningstar.

Morningstar rates each mutual fund from one (worst) to five (best) stars, like below.

The following is right from the Morningstar website:

What is the star rating?

The Morningstar Rating for funds, often called the star rating, is a purely quantitative, backward-looking measure of a fund’s past performance, measured from one to five stars. Star ratings are calculated at the end of every month.

How does the star rating work?

The Morningstar Rating methodology rates funds within the same Morningstar Category based on an enhanced Morningstar Risk-Adjusted Return measure. To receive a Morningstar Rating, a fund must have a record of more than three years.

How is the star rating used?

The Morningstar Rating helps investors assess a fund’s track record relative to its peers. It’s intended for use as the first step in the fund evaluation process.

Ok…fair enough. The Morningstar star system evaluates the performance of mutual funds based on a quantitative risk-adjusted return basis with the intention of being used to evaluate funds.

I think it is reasonable to say that the idea here is a better rating equals better performance equals a better fund to invest in. A reasonable investor may even conclude that investing in mutual funds with a great star rating will provide higher returns.

Do mutual funds with higher ratings have higher returns?

In short, no.

In fact, in 2009, Morningstar themselves published the following data:

• The 2004 class of 5 star domestic mutual funds had a 5-year rating of just 3.2 stars – slightly above average. And for context, the average risk adjusted actively managed fund (the majority of these ones) underperformed its index benchmark by about 2%
• The 2005 class of 5 star domestic funds had a 5 year rating of 3.1
• And finally, the 2006 class of 5 star domestic mutual funds had a 3 year rating of 2.9

Based on this data from the horse’s mouth, choosing 5 star funds for your portfolio actually gave you average (if lucky) or less than average risk-adjusted returns. If you went to a 5 star boutique hotel and got a Holiday Inn room (while paying more!), you certainly would be disappointed.

Let’s look at some more data…

The Vanguard Institute wrote a paper looking at this very issue of mutual fund ratings. They examined the excess returns of funds over a 3 year period after they were given a Morningstar rating.

In the time frame from June 1992 to August 2009,

• 39% of 5 star funds outperformed their benchmark for 36 months

This seems good, right? Well, it does until you realize that they found,

• 46% of 1 star funds outperformed their benchmark for 36 months!

In addition, the group found that most star-rating groups produced negative excess returns compared to their bench mark over 3 years. In fact, 5 star funds had the lowest probability of being able to maintain their 5 star status!

All of this data shows us that predicting future performance of mutual funds, even for those with huge databases and endless resources like Morningstar, just does not work. In fact, if you invested based on these star ratings, you would have to constantly buy and sell for new ones because they will invariably change. And your portfolio will suffer as a result of the turnover with higher fees and taxes.

It’s a loser’s game.

But what about index funds?

This one actually confused me for a long time.

In fact, I can remember selecting the index funds for my portfolio (you can see my portfolio’s performance here) and being a bit miffed about why all of them seemed to have a 3 star rating from Morningstar. Did this mean that they weren’t good funds? Even when I knew they tracked the index well and had low expense ratios.

It didn’t add up.

However, once you begin to understand the whole rating system better, it does start to make sense. And the Vanguard Institute even addressed it in their paper referenced above.

The authors explain, “the natural distribution of the actively managed fund universe around a benchmark (the index) dictates that an appropriately constructed and managed index fund should fall somewhere near the center of the distribution.”

In normal lingo

What this means is that, yes, there will be some funds over the previous 3 years who beat the index benchmark. They will be located to the right of the distribution of all funds’ performance. And they will get a 5 star rating.

And there will be some funds the underperform the index benchmark. They will fall of the left of the curve and get 1 star ratings.

And everything in between.

But a true index fund that tracks the benchmark will get returns that are right about in the middle. (Before taxes and fees are considered. Index fund returns will actually fall a bit to the right of center due to lower costs on an after-tax, after-fee basis.)

But indexes have stamina

However, as the data above demonstrates, over the following 3 years, those 5 star funds are more likely to underperform the index. Meanwhile, some of the 1 star funds will outperform the index.

And we just cannot predict which will be which.

But what about the index fund tracking the benchmark index? It stays right in the middle of the distribution (but really just to the right of the distribution).

Thus, some other fund may win the short term battle, but the index fund will win the war…

So where does this leave us?

Well, it really leaves us right where we began. Mutual fund picking, just like stock picking, doesn’t work. Especially if those mutual funds are actively managed by managers trying to stock pick and time the market.

Unfortunately, mutual fund rating systems are only as good as the data used to make them. In the case of actively managed mutual funds, the data forming the rating systems is based on the erratic and unpredictable nature of trying to predict stock market.

That makes these rating systems just as erratic and unpredictable as the data shows. Investing based on these systems will more likely give you subpar returns at a higher cost due to turnover, taxes, and fees.

What’s the solution?

1. Ignore the star ratings
2. Choose your asset allocation
3. Invest in the overall market via broadly diversified, low cost index funds
4. Rebalance your portfolio once a year

Do this and you will be on your way to financial freedom!

Looking for more? Check out my best-selling book, Money Matters in Medicine, and watch my Masterclass Webinar on The 12 Steps to Financial Freedom for Physicians here!

What do you think? Have you invested based on these mutual fund rating systems? How did it work out? Do you still use them? Let me know in the comments below!