In the new world of ETFs, it seems almost archaic to talk about Morningstar’s mutual fund ratings. But with many investors still being stuck in 401ks with only mutual funds a choice, it’s still a valid topic.
MarketWatch reports that “Five-star mutual funds don’t live up to their past:”
Tim Courtney decided he’d had enough. In meeting after meeting this year, he and his colleagues at Burns Advisory Group had recommended mutual funds to prospective clients, only to be hit with the same response almost every time: Why are you telling me to invest in a three-star rated fund?
That sums up the way many investors allocate money to funds — look at products that have four- or five-star ratings from investment researcher Morningstar Inc., take that as an imprimatur of quality and hope for the best. Such decisions are perhaps even more common in volatile markets, when anxious investors view top-ranked funds as somehow better-equipped to handle adversity.
Five-star funds in particular seem to have their own allure. Even in 2008’s brutal market, when the other star-rated funds saw net outflows ranging from $111 billion for three-star funds to $14 billion for four-star funds, five-star funds enjoyed $67.5 billion in net inflows.
The trouble is that investors seem to forget that star ratings look backward based on a fund’s past performance, and studies have shown the ratings have no predictive value.
“Having to get over that hurdle [explaining how star ratings shouldn’t influence choices], every time we recommended a fund that wasn’t five-star, is something we have to do time and time again,” said Courtney, chief investment officer of Burns Advisory, which manages about $300 million and advises about $150 million of 401(k) assets.
So Courtney and his colleagues went back to Dec. 31, 1999 and studied the subsequent 10-year performance of five-star funds. What he found might convince investors to kick their star-rating habit.
Of the 248 stock funds with five-star ratings at the start of the period, just four still kept that rank after 10 years. The 218 domestic stock funds with the rating typically lagged their category averages over the period — not just the benchmarks, but other mutual funds. The exceptions were 30 foreign large-cap funds, which had a 10-year annualized return of 1.44% compared with their category average of 1.32%.
In other words, it’s not just that five-star funds don’t, on average, continue to lead their peers, but they actually do worse in subsequent years.
There is much more to this article; if the subject interests you, be sure to read the entire link.
Personally, I have never seen the value of that rating system; I have found that if you wait long enough, your favorite 5-star fund may end up in the 2-star category and vice versa.
Using these ratings, investors get lulled into a false sense of security by believing that highly rated funds will hold up well in all types of market conditions. That false belief has turned into a very expensive lesson as the bear markets of 2001 and 2008 have clearly demonstrated.
I don’t care what rating a mutual fund has, whether it’s no load or load with high or low annual expenses; it will get clobbered when a bear market strikes—period. Only by being out of the market altogether during lengthy downturns can you avoid a serious portfolio haircut.
Sure, if you have assets in a 401k plan, you could use the ratings system to make your choices at the beginning of a bullish period, as long as you’re aware of the shortcomings once that trend comes to an end.
Better yet, use the 401k section of my StatSheet to verify that your selected 5-star fund is showing indeed upward momentum to justify a purchase.
The bottom line is that whether mutual funds or ETFs are on your equity menu, you need to recognize that neither will protect your principal during lengthy downward trends (unless they’re bear market funds). If you haven’t learned this valuable lesson from history, you’re doomed to repeat it.