Shooting Morningstars

No one knows more about mutual funds than Morningstar. Its web site provides data on approximately 350,000 investment offerings, but it is best known for the "star" system of ranking mutual funds (from a low of 1 to a high of 5 stars).

Brokers love the star system and often use it as a basis for recommending mutual funds. How many times have you heard "the fund has a 5 star Morningstar ranking"?

One study found that upgrading a mutual fund's star rating results in a significant positive "abnormal" flow of funds into that fund.

I was surprised by a recent article by Russel Kinnel, Morningstar's director of mutual fund research. If anyone should be extolling the benefits of the Morningstar system, you would think it would Mr. Kinnel.

Mr. Kinnel reviewed data on the predictive value of expense ratios (the stated costs of running the fund, which are deducted from returns) and the Morningstar ratings. His conclusion is unequivocal: "Expense ratios are strong predictors of performance. In every asset class over every time period, the cheapest quintile produced higher total returns than the most expensive quintile." He also found the star ratings can be "helpful", but "[I]nvestors should make expense ratios a primary test in fund selection."

Mr. Kinnel addresses how highly rated Morningstar funds generally perform. However, he does not compare the performance of these funds to comparable index funds. I can understand this omission. One study reported by Vanguard founder John Bogle reviewed the total return of Morningstar's top-rated domestic stock funds for the period 1993-2000. They averaged 106%. How would investors have done if they simply purchased a low cost index fund that tracked the Wilshire 5000 index (like Vanguard's Total Stock Market Index Fund [VTSMX])? The index returned a whopping 222% during the same period.

In the same paper, Bogle looked at the performance of Morningstar's designated mutual fund "Manager of the Year" from 1987-1995. These are supposed to be the brightest stars in the mutual fund universe. Bogle found their stars dimmed significantly in the years following their lofty designation. As a group, they underperformed a simple S&P 500 index by 2.4% for this period.

The combination of misusing the Morningstar star system and relying on brokers is a perfect storm for investors. Brokers tout the benefits of highly rated funds, without disclosing you would be better advised to invest in low cost index funds. It gets worse.

Brokers don't tell you the chance of picking any actively managed fund that will beat the market over a significant period of time is exceedingly small. One study looked at 2,076 domestic stock mutual funds over a thirty-two year period from January, 1975 to December, 2006. The authors concluded 99.4% of all fund managers failed to demonstrate true stock picking ability.

Here's the takeaway:

• Morningstar ratings are not a sound basis for selecting mutual funds;
• Focus on low cost index funds;
• Your broker is a poor source of advice for selecting mutual funds that will outperform the market.

Remember the admonition of the first American Nobel laureate in economics, Paul Samuelson: "It is not easy to get rich in Las Vegas, at Churchill Downs, or at the local Merrill Lynch office."

Ed's Note: This blog post has been amended from its original version to more accurately reflect Mr. Kinnel's rating of Mornigstar funds.

The views set forth in this blog are the opinions of the author alone and may not represent the views of any firm or entity with whom he is affiliated. The data, information, and content on this blog are for information, education, and non-commercial purposes only. Returns from index funds do not represent the performance of any investment advisory firm. The information on this blog does not involve the rendering of personalized investment advice and is limited to the dissemination of opinions on investing. No reader should construe these opinions as an offer of advisory services. Readers who require investment advice should retain the services of a competent investment professional. The information on this blog is not an offer to buy or sell, or a solicitation of any offer to buy or sell any securities or class of securities mentioned herein. Furthermore, the information on this blog should not be construed as an offer of advisory services. Please note that the author does not recommend specific securities nor is he responsible for comments made by persons posting on this blog.

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Comments

[mrspiffy]

11:51 AM on 09/15/2010

Yeah...but if you've owned the S&P 500 index fund for the last decade you've...
A. Made absolutely NO money if you drank the buy and hold kool aid
B. Got enjoy the scarya** downs as well as the mediocre ups.

Asset allocation is the key and there ARE good actively managed funds out there as well as good advisors.

http://yieldpig.blogspot.com/

[Tony Dubon]

11:07 AM on 09/15/2010

The advice in the article is excellent. I like a couple of books by John Bogle, the founder of Vanguard: Common Sense on Mutual Funds, and The Little Book of Common Sense Investing. As the creator of the first index fund, Bogle presents the case for them. One should include them as part of a portfolio of mutual funds.

I want to make the case for actively managed funds as well. There is a very good rationale for positing that past performance can identify funds likely to outperform in the future. Actively managed mutual funds are decision-making machines. Their decision-making capability is the bottom line result of people, processes, approaches, and tools that they use every day to make decisions. Good machines are more likely to make good decisions than bad machines. This capability to make consistently good decisions can be inferred from past risk, return and persistence behavior. Persistence is the tendency of a fund to exceed S&P500 return at lower than S&P500 risk. A tool that provides this analysis is available at www.FundReveal.com and a free trial is available. Full disclosure: it is my business. But it provides a unique approach to the selection of mutual funds based on objective analysis and statistics. Check out the backtesting. It works.

[blueken]

10:52 AM on 09/15/2010

I beat this horse to death, but one more time, Trust. Our financial system has eroded national and international trust in the service of greed. There is a lot of 401k money sitting on the sidelines waiting for a good reason to once again trust the brokers and the investment houses. I think if we want the economy to really get rolling again we need sensible regulations so that trust in our financial instritutions is restored. We have seen time and time again, that left to their own devices, those that we trust with our savings will do what is best for them, not us. There was a time when the United States was seen as a safe place to invest around the world. Not anymore, not even in this country. Let's get those regulations back that made our economy something to invest in.

[Linda from Deerfield]

09:06 AM on 09/15/2010

It is refreshing that somebody is taking the trouble to rightfully point out that Morningstar ratings have been as useless -- indeed, destructive -- as we judge Moody's and S&P to be. By following the Morningstar rating of Schwab Yield Plus, I came to understand that the rating represented nothing more than a summary of past performance and not one bit of a deeper look than anyone with a prospectus and performance data could get, so after the falsehood of the fund's designation as an ultra short bond fund came to light -- it was secretly loaded with toxic mortgage securities -- Morningstar finally slightly reduced the 5 star rating, still ignoring the fact that there would never be a way for the losses from selling the toxin to be recouped.

[bayernishe231]

08:35 PM on 09/15/2010

People need to take some personal responsiblity. If you would have taken a peak of the first 3 paragraphs of the prospectus you would see the follow items:

"The fund may invest in bonds with effective or final maturities of any length and may invest up to 25% of its assets in below investment grade bonds (sometimes called junk bonds)"

"The fund may invest in derivatives including, without limitation, futures, options and swaps (including credit default swaps), which relate to fixed income securities, interest rates and other assets and related indices."

Not so secretly loaded with "toxic" assets... it is Yield PLUS (more yield = more risk).. YOUR FAULT for not reading the prospectus.

[Linda from Deerfield]

09:28 AM on 10/01/2010

Belatedly, I must tell you that the courts do not agree with your interpretation. The class action suit is going nicely and it appears that we will get back about $10,000 -- close enough to whole that the meltdown becomes a non-event for us. You must be looking at a newer prospectus and also ignoring the memo that assured investors that no more than 5% of holdings were mortgage backed, which proved to be untrue. I was deceived, and it appears that on occasion there is justice for victims. I thought you might need to know for fine-tuning your perception of reality.

[Russ Kinnel]

10:48 PM on 09/14/2010

Actually, I did write about how the star ratings performed. There's even a section with the heading "How the Star Rating Performed." In fact, the rating performed well. It helped investors make better decisions almost as much as expense ratios. The success ratio--the chance of picking a fund that outperforms and survives--for star ratings beat the expense ratio nearly half of the time. So, yes the expense ratio is the best predictor, but the star rating is a close second. You may want to give the article I wrote another read. Here's the link. http://news.morningstar.com/articlenet/article.aspx?id=347327&part=2

[dansolin]

10:54 AM on 09/15/2010

Mr. Kinnel is correct. His article does discuss the performance of funds rated by Morningstar. I indicated that he noted the star ratings were "helpful" to investors, albeit less helpful that reference to expense ratios. I meant to indicate that his article does not discuss how highly rated funds compare to benchmark indexes. I should have made this distinction more clear and appreciate his bringing it to my attention. In another communication, he states that I provide no source data for the data I used in my blog on this issue. However, my blog hyperlinks to the Bogle article which is the source for this data. The bottom line from my perspective is that investors would be better off buying a low cost, globally diversified portfolio of index funds rather than relying on Morningstar's star ratings. If Mr. Kinnel has contrary data, I would be happy to review it and to publicize it.