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:
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.
[i] If the two thumbs up are enthusiastic, all the better.
[ii] We aren’t picking on Morningstar, which has plenty of useful features—they’re just the latest raters in the spotlight.
[iii] Morningstar or other rating.
[iv] Meaning, the top 25% of funds studied.
[v] Source: FactSet, as of 10/30/2017. S&P 500 Price Index from 9/16/1929 – 10/27/2017.
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*The content contained in this article represents only the opinions and viewpoints of the Fisher Investments editorial staff.