Before investing in mutual funds, many investors inquire about the Morningstar rating, or star rating of a particular fund. If it has a high rating, they assume that it is a good fund to invest in. But is it? Just because someone else thinks a mutual fund is good to invest in doesn’t necessarily mean it is. You may be surprised to find that in the end, most of the Morningstar ratings don’t really matter.
Who is Morningstar?
Morningstar is a US based research firm that publishes data on both stocks and mutual funds. It is best known for its star rating system, where it provides investors with a sense of a fund’s performance. The start system rates funds from worst (one star) to best (five stars). Even if you have never visited the Morningstar website, you have most likely seen the star rating system. Open up virtually any personal finance magazine and the mutual fund companies that are advertising their funds will list their three and five year Morningstar rating.
According to the Morningstar website, Morningstar claims to bring risk and performance together through a complex math formula to determine each funds rating. The overall concept assumes that most investors are more concerned with losing money versus a good outcome that they were not expecting.
Taking into account the above definition of the rating system, the best performing funds, five star funds, have the highest risk-adjusted return and the worst performing funds, one star funds, have the lowest risk-adjusted return.
My Issue with Morningstar
The biggest issue that I have with the rating system is that it assigns star values to funds based on past performance. Any smart investor knows that past performance is not a predictor of the future. Granted, Morningstar does continually update their data on a monthly basis, but the fact still remains that a fund that has performed highly in the past will get a high star rating. Just because it performed great in the past doesn’t mean it will continue to do so in the future. I feel the system can mislead investors.
But is my concern valid? Maybe the Morningstar rating system is able to help investors pick winning mutual funds.
Professor Christopher Blake of Fordham University and Professor Matthew Morey of Pace University conducted a study from 1992 through 1997 to see if funds had a higher return based on the star rating system used by Morningstar. Their results were interesting.
When it came to the worst performing funds, those with one star, the researchers found that these funds were inclined to continue their below average performance in the future.
For funds with a rating of three, four and five stars, the researchers found very little evidence of these funds having superior performance. In other words, a three star fund was just as likely to have the same performance of a five star fund for the same period in the future. Another way to put this is today’s five star fund can easily become tomorrow’s three star fund and vice versa.
How To Effectively Use The Morningstar Rating System
I recommend against using Morningstar star ratings as your sole research tool when choosing funds. I recommend looking at a funds management fee, turnover, and any load it charges first. Then I would look at the Morningstar rating just to see if it has one star. If it does have one star, I would pass on investing in it. The study noted above validates this for me. If the fund has a Morningstar rating of three stars or more, then I know I can continue to do research to see if the fund is a good fit for my portfolio.