Overview: Morningstar's star-rating system is widely used to compare mutual funds. Should investors rely on these rankings? The following discusses why investors should not simply gaze at the stars.

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When choosing types of mutual funds, many investors go straight to the fund’s rating from Morningstar. The logic is simple: five-star funds are the best, so these funds should be the obvious choices. However, investors would be wise to step back before pouring money into a mutual fund based on its rating.

 

Numerous studies have been conducted on the predictive power of the Morningstar ratings system, with most reaching the conclusion that the system has little (if any) predictive powers. Generally speaking, the system can identify the funds that have consistently poor performance (either by poor stock selection, bad market timing efforts, high expenses or combinations thereof), but cannot identify future outperformers with relative consistency. And most investors would not be happy with funds that only used to perform well.

 

In 2002, Morningstar reconstituted its rating system in hopes of improving its predictive powers. Previously, Morningstar placed funds in only four categories. Under these groupings, funds that focused on the hottest sectors could gain an edge in the rankings. For example, in mid-2000, three-quarters of funds that invested in large, fast-growing companies garnered four or five stars. At the same time, only six of the 123 funds that specialized in small, bargain-priced stocks earned such a ranking.¹

 

Today, Morningstar uses 48 groups — such as small-cap value, foreign large-cap growth and global real estate — with the intention of better classifying funds and providing a more apples-to-apples comparison.

 

Also, Morningstar used to judge the riskiness of a fund by simply comparing its average performance to that of the 90-day T-bill. If the fund beat the T-bill, it was considered safe, so even funds with highly volatile returns could be considered safe if they simply beat the benchmark. According to this standard, many technology funds were considered safe in 1999, even though they ended up suffering significant losses in the 2000–2002 bear market.²

 

According to Morningstar, now “risk is measured as the amount of variation in the fund’s performance, with more emphasis on downward variation.”³