Don’t Let the Stars Get in Your Eyes
by
Member of the Firm
"I own last year’s top performing funds. Unfortunately, I bought them this year."
~ Anonymous
Next to the belief that active management is a winning strategy, (i.e., that you can outperform the market by trying to pick the future winning stocks or time your market participation), the strongest piece of conventional wisdom about investment performance is that the past performance of investment managers can be prologue to future performance. Unfortunately, just because something is conventional wisdom doesn’t make it correct.
One approach that some investors use to select mutual funds is to rely on the information provided by Morningstar, the popular rating service that rates funds using a star system similar to the one used by film critics. Ads touting funds with four- and five-star ratings may convince some investors that the stars have predictive value. A study that covered the period January 1995 – August 1995 found that an amazing 97 percent of fund inflows went into four- and five-star funds, while funds with less than three stars experienced outflows.
Morningstar gives the coveted five-star rating to the funds it believes are among the top 10 percent, and a one-star rating to the bottom 10 percent. The Hulbert Financial Digest tracked the performance of five-star funds for the period 1993–2000. For that eight-year period, the total return (pretax) on Morningstar’s top-rated U.S. funds averaged 106 percent. This compared to a total return of 222 percent for the market, as measured by the Wilshire 5000 Equity Index. The study also found that the top-rated funds, while achieving less than 50 percent of the market’s return, carried a 26 percent greater relative risk (as measured by standard deviation).
Another study by The Hulbert Financial Digest looked at a portfolio of 55 funds that Morningstar rated highest for the period January 1991 – March 2002. This portfolio, which bought funds when they climbed into this elite group and sold funds when they dropped out of the five-star rating group, trailed the market by 6 percent per annum after paying sales charges, redemption fees, and other transaction costs. A study by Morningstar found that one-star funds outperformed five-star funds by 45 percent for the period 1995 – 2001.
John Rekenthaler, vice president of new product development for Morningstar’s global operations, has commented frequently on the use of the star-rating system and choosing actively managed funds. According to the Wall Street Journal, when asked how to pick a winning fund, Rekenthaler responded: “We should have more answers.” And commenting on whether investors should pay attention to mutual fund advertisements, he added: “To be fair, I don’t think that you’d want to pay much attention to Morningstar’s star ratings either.” In 1999, Rekenthaler told Fortune that actively managed funds were beginning to show up on his cultural radar as a “marketing scam for suckers.”
Before trying to find the future superstar funds, carefully consider these words of wisdom from Jonathan Clements, reporter for the Wall Street Journal: “When we buy an actively managed fund, we are like gamblers in Vegas. We know it is likely to be a losing proposition, yet somehow we feel we are getting our money's worth.”
This material is derived from sources believed to be reliable, but its accuracy and the opinions based thereon are not guaranteed. The content of this publication is for general information only and is not intended to serve as specific financial, accounting or tax advice.