A recent Wall Street Journal front page story, “The Morningstar Mirage,” stated what most advisers should already know: Morningstar ratings don’t mean much. In my experience, those who rely upon star ratings do so for one of three reasons:
- Selling. Any typical run-of-the-mill rep knows how to screen for five-star funds and put together a recommended portfolio. Once presented, he’s hoping the potential client says: “Wow, you’re really good at picking funds. My current portfolio doesn’t have nearly as many stars. You’re hired!”
- Rear-end coverage. When evaluating funds for retirement plans, foundations, or other fiduciary scenarios, the star rating is a well-known independent validation tool. If things get dicey, it’s much easier for a fiduciary to defend a decision to retain a five-star fund rather than a two-star fund.
- Laziness and lack of skills or knowledge. No explanation required here.
Why are the fund star ratings so poor at predicting future performance?
At the most basic level, my answer would be that the “why” doesn’t matter. But there is something called regression to the mean that tends to play out here. In a highly efficient and competitive market, performance tends to move toward the mean of all funds. Over time, really lucky fund managers start to have less luck. Therefore; their overall performance starts looking more average. It happens to all of the great investment gurus eventually. It happened to Peter Lynch and it’s happening to Warren Buffet.
A side note: Some people incorrectly argue that it’s better to buy one and two-star funds, thinking their regression could point to future over performance. This is not a statistically accurate assumption. Poorly rated funds could have high costs, poor investment criteria, or a whole slew of other problems. There are some really bad mutual funds out there and we should stay away from them.
The value of Morningstar research & tools
Morningstar ratings are a poor way to pick mutual funds, but Morningstar is still a great company that provides vital information to investors and professional advisers. Morningstar produces the data I use on a continual basis to make mutual fund decisions. Return is easy to find, but digging deeper to understand the costs associated with each fund, compare similar funds, and look at fund managers, investment objectives, etc. is critical.
Morningstar’s ratings aside, the company’s tools continue to prove valuable for the type of in-depth research and analysis that advisers should be doing. Interested in learning more about how Schulz Wealth evaluates mutual funds and other investment options? Contact me to learn more about our process.