10/30/2007 11:16 am ET Updated May 25, 2011

Fallen Stars

The Morningstar "star" system is often used by brokers and advisors to pitch hot mutual funds. A five star rating means huge inflows for mutual funds. A one or two star rating can mean significant outflows as investors flee these funds.

Over the years, there has been considerable research demonstrating that high Morningstar ratings are not predictive of future performance. Some of these studies demonstrated little difference between the performance of five star and three star funds in the years after the rating was given.

A new study by Professors Morey and Gottesman of Pace University concludes the opposite. The study looked at Morningstar rated, domestic equity funds for the three year period from July, 2002 - June, 2005. They concluded that "higher rated funds, for the most part, significantly outperform lower rated funds."

So, should you run out and buy five star rated funds?

Not if you are interested in superior returns.

With minor exceptions, the study found that, in all star categories, index funds outperformed all of the rated mutual funds.

This finding is not mentioned in the "Conclusions" to the study, which focuses on the predictive power of the higher rated funds, thereby missing the point. Why should investors care if five star funds outperform four star funds, when index funds outperform five star funds?

Another study of mutual funds selected by Morningstar for its own 401(k) plan found that these funds significantly underperformed a broad U.S. market index for the period 1991-1999. The same study found that funds designated as 'top performing" by Forbes, The New York Times, Worth magazine, BusinessWeek and 59 investment newsletters studied over a 10-year period all underperformed the same index.

The next time your broker extols the virtues of a five star rated fund, tell her you want a six star index fund!

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.