With the turn of a new year, results in the 2012 race for the coveted Morningstar star rankings will soon be announced. Morningstar has done such a good job of marketing their ranking system that not a few careers rest on whether a fund makes it to the 5-Star level. The problem is that the ranking system is seriously flawed in its measurement of success and its predictive capabilities. Laggards and leaders, tortoises and hares are not so easily determined.
First, let’s point out the obvious. If there’s a mutual fund with a really good historical track record out there, it’s almost guaranteed to receive 5 stars. The only thing 5-stars really says, however, is that any investor who WAS with this fund over the last several years probably had a pretty good return. It says nothing about whether the future will be good.
Now, let’s point out the not-so-obvious. If there’s a really great mutual fund that hasn’t had a particularly good run recently, but is nonetheless a fantastic fund which will bounce back, Morningstar may still ding it. There are great mutual funds that do NOT receive very many stars, and they may well appear to be dogs. Why might this be so? There are two primary reasons.
By its own admission (cited in Javier Espinoza’s Wall Street Journal article on January 4, 2013), Morningstar doesn’t attempt to cover all mutual funds. If the best mutual fund manager in the world steps out on his or her own to open a new fund, there is absolutely no guarantee that Morningstar will review the fund. It wouldn’t have any rating at all, and anyone researching it through Morningstar would think it stinks. That’s a pretty glaring error, but hey, it’s the large mutual fund companies that advertise the most, and Morningstar was very clear in pointing out (cited in the same article) that they cover all the large funds.
The other reason Morningstar stars don’t have the predictive capability they’d like us all to believe is that they have no way of mitigating the fact that almost all mutual funds with superior, or even extraordinary, 10 year track records have under-performed for at least 3 consecutive years of those 10 years.
What do we mean by that? Let’s look at an example and then some statistics. Pretend that the Acme Mutual fund has out-performed the market for the last 10 years ending 2012. If Morningstar’s system was perfect, it would have given the Acme fund a 5-star ranking every year of the last 10.
But let’s say that in the 3rd, 4th and 5th year of these 10 years the Acme fund lagged the market by 5% in each of those three years. Morningstar would not give the Acme fund a 5-star rating for those years. If an investor made decisions based on the star system, the investor would not have invested in Acme, and yet Acme’s return in future years would have been so good that its overall 10-year performance would beat the market.
The statistics bear this out with some degree of regularity. In one recent study of all the large cap and small cap stock mutual funds that exceeded the market by 2% per year over a 10-year period, 71% of them had a bad 3-year run where they under-performed by 5% per year.
It takes a lot of patience to stay with a mutual fund that is under-performing 5% per year for 3 years straight. The media reports would be lousy, and Morningstar would probably give it a fairly low rating. And yet, patience is exactly what’s needed. In order to out perform the market over the full 10 years, investors have to stay with a great mutual fund like this for 10 years. Morningstar’s stars don’t help you do that.
Some commentators have suggested that while this may be true, the best strategy is simply to stick with mutual funds that have had beaten the market for 10 years and forget about what happens in the middle. More than likely, these funds would have 5-star rankings, so they’d be easy to find with a simple Morningstar search.
Wouldn’t it be nice if it were that easy! The key problem here is that a mutual fund doesn’t have a mind of its own. A mutual fund doesn’t generate earnings or generate growth. It is the manager of the fund who does that. In every mutual fund, there is a person – a real live human – who makes the decisions what to buy, what to sell, when to buy and when to sell. A mutual fund is good or great because the actual manager making the decision is good or great.
It would seem then that if a manager has been good or great for 10 years, and investor might want to immediately invest in that mutual fund. Appears to be a pretty logical conclusion except when you consider the fact that the turnover rate for mutual fund managers of top performing mutual funds is 57% to 73% (as cited by a 3/17/11 University of Rochester study). In other words, more than half the time, the guy or gal who made those fantastic investment decisions leaves the fund to pursue other career options – usually a better offer from a competing mutual fund.
If you simply try to invest in a mutual fund with a great 10-year track record, it is a flip-of-the-coin as to whether future performance will be as good as past performance. But, boy, look at that Morningstar 5-star ranking!
The bottom line here is that Stars, bells or whistles are not very good reasons to buy into, stay with, avoid or leave a mutual fund. Knowing who is managing the fund, what strategy they are following, and whether that strategy is going to be successful in the future are really the important criteria. But those can’t be distilled down to a cute star ranking system. To do it right, you really need to know how to research mutual funds.
Thankfully, there are independent advisors, like us, who do this. We’re Fee-only! No commissions, no confusion. Our only special interest is the client.