Morningstar not necessarily a predictor

Most investors are familiar with the Morningstar “5-star” rating system. Chicago-based Morningstar assigns mutual funds one of five levels of star ratings - one star is the lowest ranking and five stars is the highest. Morningstar uses the funds’ performance records over the past three-, five- and 10-year periods to arrive at its rankings. The company’s complete methodology can be found on its Web site.

In short, Morningstar measures a fund’s risk-adjusted performance against a peer group of similar funds. The star rating is a strictly numerical calculation, and contains no subjective input from analysts. While Morningstar takes care to point out that its star ratings are not necessarily a predictor of future returns, the entire investment industry seems to embrace them as such. Many mutual fund ads merely tout the fund’s star rating and provide virtually no other information about the fund. I recently read a study that showed that over 90 percent of new money flowing into mutual funds in any given quarter goes to four- and five-star funds.

Investors, brokers and financial advisors overwhelmingly believe that a high star rating is a good criterion for choosing future winning funds. Given that fact, it is fair to ask a simple question: Does the Morningstar rating system actually serve as a predictor of mutual fund success?

Unfortunately, the actual performance record of Morningstar’s system is disappointing. At best, it can allow you to eliminate the worst funds: one- and two-star funds tend to stay that way. At worst, there are many examples of periods where the Morningstar ratings will steer you towards picking losing stock funds. Of the 434 domestic stock funds with 4-5 stars in the years 1997-1999, 273 of those funds (62 percent) went on to finish in the bottom quartile of stock funds in 2000-2002. Only 11 of the 434 stayed in the top quartile in the ensuing three years.

No less an authority than Nobel Prize winner William Sharpe has studied the predictive power of Morningstar’s rating system. He concluded,

“… Morningstar’s measure [is not] an efficient tool for choosing mutual funds within peer groups when constructing a multi-fund portfolio - the ostensible purpose for which Morningstar’s rankings are produced.”

In another comprehensive study completed by professors at Fordham University and Pace University, the authors concluded that,

“… there is little statistical evidence that Morningstar’s highest-rated funds outperform the next-to-highest and median-rated funds.”

The objective evidence is overwhelming that the Morningstar rating system does almost nothing to predict winning funds.

I understand why advisors and brokers use Morningstar. If your business is to sell investment products, you want to let your target client know that you only sell the “best” products. Trotting out the Morningstar rating generally says all a prospective client needs to hear.

If the Morningstar ratings do not predict future winning funds, how should you go about making such selections? As with most investment decisions, such choices cannot be made by simply calculating statistics. As another Nobel Prize winner - and Pacific Beach resident - Harry Markowitz said, these choices, “Require the judgment of reasonable men [and women].” While Markowitz won his Nobel for a statistics-based decision process, he is among the first to admit that, in the end, the wise investor makes a judgment call.

In making this judgment call, I rely heavily on good old-fashioned interview skills. Just as when hiring an employee or choosing an advisor, you need to ask tough questions and check out the fund manager’s background. Does the manager have a disciplined process that is followed throughout the organization? Is the team stable, with long-tenured analysts? Does the particular stock-picking process provide a clear edge over other managers? Is the manager distracted with multiple funds, book tours, and TV interviews? Is there a clear, long-running pattern of commitment and success? Does the fund team put shareholders first?

None of these factors go into the Morningstar or Value Line ratings, but in my experience, they are the crucial factors that help to predict future success. Another benefit to choosing funds this way is that you end up with a collection of funds that will need very little changing over time. Just like the process of hiring a good employee, if you spend the extra time up front to get it right, you don’t need to do it again for a long, long time. After all, a mutual fund manager is your employee - hired to look after your money.