Morningstar Rankings - How Effective Are They?

With literally tens of thousand of mutual funds to choose from, it’s hard to know where to begin.  But, it seem that everywhere you look in the investment world, when discussing mutual fund options, people want to give you the Morningstar rating on the fund.  These ratings are in magazine articles, on brokerage sites, and sometimes on the fund web sites themselves.  Since everyone seems to use them, you probably assume they must give you some big edge.

We’ve seen some articles in the past that were not very complimentary of the Morningstar system.  But, giving them the benefit of the doubt, we though we’d take a look around Morningstar’s own web site, and just see how useful these ratings are. If anyone could paint a rosy picture, it would seem they could.

Let’s start with the article “Getting the Most Out of Star Ratings and Analyst Picks.”  Here you find this quote:

“How Not to Use It

Although the star rating can be a handy tool for monitoring your funds’ performance, you shouldn’t construe it as a buy and sell signal. Because we recalculate funds’ star ratings every month, funds frequently gain or lose a star, and that action can best be described as “noise” that you should tune out. Moreover, a fund isn’t automatically worth buying just because it earns a 5-star rating. …. ”

Of course, that’s what everyone wants to do with them, so why say that? It appears they say that because it’s true!

Well, here’s how well the star ratings really work (at least according to Morningstar).  In” Rating the Star Rating” on the Morningstar site, the predictive performance of the star ratings was measured over the 2 years ending June 2005.  Here are the average returns over that period:

5 Star Funds   15.53 %
4 Star Funds   14.19 %
3 Star Funds   13.92 %
2 Star Funds   13.81 %
1 Star Funds   13.24 %

All this fuss over star ratings and the spread from high to low is just over 2% in return! 

But they also look at other fund categories.  The 3 year returns for international equity funds broke down like this:

5 Star Funds   15.3 %
4 Star Funds   15.1 %
3 Star Funds   14.1 %
2 Star Funds   12.5 %
1 Star Funds   16.7 %

The 1 star funds had the best returns of all! 

The article sums it up, “Investing is much too complex for any single measure to sum up the entire merit of a security.”  So, it’s not clear what the point of having them is then.

Filed under Mutual Funds

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