Mutual Fund Ratings and Past Returns

Most people prefer to watch movies that got two thumbs up^[i] from the critics. The best restaurants in the world get Michelin stars. Critics award wine “points.” Online shoppers buy top-rated products from top-rated sellers. Higher ratings mean better products, right? So it’s no surprise folks also seek out investments with high ratings—whether measured in stars, medals, “buy” recommendations or something else. In our view, however, relying on these ratings is misguided: Fund ratings don’t aid investors’ decisions, as they are mostly an incomplete analysis of past returns—not predictive.

This isn’t just our opinion. A recent Wall Street Journal investigation found Morningstar mutual fund ratings don’t predict future ratings or returns for said mutual funds.^[ii] Highly rated funds usually fall back to earth and/or disappear. To quote:

“Of funds awarded a coveted five-star overall rating, only 12% did well enough over the next five years to earn a top rating for that period; 10% performed so poorly they were branded with a rock-bottom one-star rating. … The Journal’s analysis found that most five-star funds perform somewhat better than lower-rated ones, yet on the average, five-star funds eventually turn into merely ordinary performers.”

Now, Morningstar argues they’ve never claimed ratings are perfectly predictive—they are a starting point for research, nothing more. But we’re pretty skeptical they are even helpful in this limited role. Ratings are simply opinions (influenced by past returns), not objective reflections of a fund’s future value. Thus, if you start by screening for higher-rated funds, you’ve pretty much committed the cardinal sin right out of the gate.

Nonetheless, many investors and advisers treat highly rated funds^[iii] and those with strong recent returns differently than funds at large. Fund managers tout their ratings to current and prospective customers—even purchasing the right to advertise them on billboards and in brochures. Some brokers and advisers use them as a shortcut. Why have a nuanced discussion of a fund’s holdings, their fundamental drivers and the impossibility of predicting future returns with certainty when you could simply direct folks to a highly rated mutual fund? The Wall Street Journal spoke to one financial adviser who “recalled struggling last year to explain to a company’s employees which funds they should choose in their retirement plans. He decided to keep it simple and told them, ‘You only have two funds rated by Morningstar—one’s a two-star and one’s a four-star. Go with the four-star.’ He could see a look of understanding flash across their faces.”

This shows ratings are the prime consideration for many—a fact the Journal also demonstrated by finding money flows into highly rated funds and out of low-rated as investors chase heat.

While there is nothing wrong with listening to analysts’ opinions of funds’ prospects as one component of investment research, investment decisions shouldn’t hinge on them. Here’s why: Ratings are largely based on returns, which are backward looking—showing what did happen, not necessarily what will (or is more likely to) happen. Standard & Poor’s recently released mutual fund performance persistence scorecard confirms this: “Out of 568 domestic equity funds that were in the top quartile^[iv] as of March 2015, only 1.94% managed to stay in the top quartile at the end of March 2017. Furthermore, 0.92% of the large-cap funds, 2.38% of the mid-cap funds, and 2.26% of the small-cap funds remained in the top quartile.”

This speaks to a critical flaw with ratings: They don’t tell you how funds generated their returns—nor, by extension, whether the factors driving past outperformance will likely persist. Here are some key things ratings omit:

• Mutual fund manager turnover: If a fund’s manager leaves—as they frequently do—you may not be hiring the manager who contributed to those outsized returns.
• Whether outperformance stemmed from style or geographic mandates. Mutual funds follow investment mandates in their prospectuses. These mandates are pretty static, but markets aren’t. Another recently released Standard & Poor’s report shows the consequences: Mutual funds with narrow investment styles—like value, growth or small cap—often do great when their style is in favor but lag badly the rest of the time. For example, growth-focused managers outperformed from July 2016 through June 2017, when growth stocks led the market. But from January 2016 to June 2016, they trailed blended growth and value managers. By the same token, a Tech-focused fund would look great this year—and probably scores a great rating—whereas an Energy-focused one would look much worse. You could have flipped those for the majority of the last bull market. A rating alone won’t hint at what’s driving performance.
• How a fund has performed over a full market cycle—a bull and bear market in succession. Since 1929, US stock market cycles have averaged 81 months—not quite 7 years.^[v] Morningstar funds’ performance history goes back only 10 years—and many funds are too new to fill even that timeframe. Moreover, the current bull is over eight and a half years old—which means many funds have yet to experience a full cycle. This is critical: A longer timeframe provides a more complete sample, and most styles and sectors often perform differently at different stages of a bull or bear. Without a sense of how managers navigate a variety of conditions—not just their fund’s sweet spot—investors have less to go on.
• Whether previous changes in the fund’s rating presaged—or merely followed—changes in performance. This would help you better see whether the ratings were predictive—but sadly, fund providers don’t offer it.
• Lastly, the elephant in the room—whether a fund fits your situation. Before you even get to pick funds, you need to craft an asset allocation—a mix of stocks, bonds, cash and other securities likely to meet your goals and needs. Once you do so, selecting funds or assets isn’t about picking uniform high fliers. It’s about blending together different assets to help you manage risk and expected return. Maybe you could accomplish that with all highly rated funds, but if a primary basis for the rating is past returns, that seems in doubt.

Our advice: If you’re picking funds (or managers), do your full due diligence. Don’t just look at performance history and some outfit’s opinion of that. Figure out what contributed to performance and whether those factors are still in place. This—not ratings—is a much more meaningful starting point for investment research, in our view.