Be Cautious When Studying Mutual Fund Ratings
By
Seguin & Associates Financial Services
Wherever you look, you will find various rating systems on
mutual funds, each of which uses a different approach. All
of them are designed to weed through the thousands of funds
to get to the best ones. But is there really such a thing?
Does a high rating really mean a fund will do better in the
future? Many people seem to think so. A recent study showed
that Morningstar, North America's most recognized rating
system for funds, has a tremendous influence on fund sales.
If Morningstar gives a five-star rating, those funds
typically enjoy increased sales as a result.
While ranking providers are careful to warn investors that
their ratings don't foretell the future, the star system
is, unfortunately, used by some investors as if they were
reading Consumer Reports to purchase a new drill.
Supporters of the ranking approach argue that there's no
subjective component to the star rating. It isn't
determined by an analyst's review, and can't change simply
because the service dislikes the fund's manager or its
investment strategy. And that's good.
Performance will vary. Fund performance often falls off and
risk levels rise during the subsequent three years after a
fund is given an initial five-star Morningstar rating,
suggests another recent study by Matthew Morey, a professor
at Pace University. One reason for this is that after
receiving a five-star rating the size of the fund grows
dramatically, which then makes the fund unwieldy to manage,
he suggests. Since Morey's study was completed, Morningstar
also has changed the way it doles out top rankings to make
them more precise. One of the biggest problems with all
rating systems is that they are not necessarily predictive
in nature. This means they're not really set up to tell you
whether certain funds will necessarily do better in the
future. For the most part, the ratings indicate how much
you might have made and how much aggravation you faced in
the process.
Combining risk and return. For example, one five-star fund
might post moderate return scores, but incredibly low risk
scores. Another five-star fund might have much higher-risk
scores, but its return score could be strong enough to help
it still rank in the top 10% of the pack.
In some cases, in fact, it's not even the same fund to
begin with. Remember, after a management change, the rating
stays with the fund, not the portfolio manager. Therefore,
a fund's rating might be based almost entirely on the track
record of a manager who is no longer with the fund.
Understand how the ratings were developed. Too many people
put emphasis on the results without knowing how the results
were achieved. If you are going to use ratings, take the
time to understand how they were developed and what they
really mean. It is not the destination but the journey that
counts.
Past performance is no guarantee of the future. You have
probably heard this disclaimer a thousand times before, but
it is really important to understand. Most rating systems
have little to no predictive element in them. It's natural
to think that the best performer of the past will be the
best performer in the future. Unfortunately, it's not that
simple. Just think about it; if it were that easy,
investors would just continue to buy last year's winners
knowing that they will be this year's winners. And that
seldom works.
Ratings are a very important element in trying to
distinguish between good and bad funds. Good research,
however, goes far beyond just looking for five stars or an
A+. When evaluating funds, look at the quantitative,
measurable characteristics of a fund: returns up against
the benchmark, costs, risks, taxes and manager tenure. Use
rating systems as part of your research, but remember: just
because the analysts give them top marks, it does not mean
they will be the best investment in the future, and
doesn’t it mean that they'll be the best investment
for you in particular. Take the time to understand how the
ratings were achieved. This will be the first step to
educating yourself about funds.
About the Author:
http://www.seguin-associates.com/
Seguin & Associates Financial Services Ltd. is a
financial planning service located in Windsor,
Ontario. They are dedicated to the delivery of
professional retirement planning, estate planning, tax
planning and life insurance.
Source:
www.isnare.com