Not all star ratings are the same. I thought that after Maureen and I recently were planning a vacation. As we were trying to plan on what hotel to stay in and what restaurants to enjoy, we did the normal tourist activity of reviewing the potential locations online to see what the hotel ratings were, as in how many stars that they had achieved. We also did this for the restaurants that looked appetizing on our searches.
The ratings for hotels and restaurants can be very helpful. You can be confident that if a hotel has achieved a five-star rating from Michelin or a restaurant has received a four-star from Zagets that the accommodations and meal will be excellent. Just as importantly, these ratings have you avoid the low rated hotels as they will clearly live up to the low rating.
However, if investors take this approach when trying to determine where they should invest their money, they are making a mistake. They often look to the Morningstar rating system to determine what rating a particular mutual fund achieved to determine if they should invest. Unfortunately, this rating does not result in a similar understanding of what they will achieve or receive in the future.
The pull of the Morningstar four and five star ratings (their top two ratings awarded to approximately 33% of the funds) is obvious. The US mutual funds that had achieved these top 2 ratings captured approximately 86% of the money invested between 2008 and 2012 in US mutual funds. But does the Morningstar rating have the ability to accurately forecast future performance ? To state it succinctly – No.
While restaurants and hotel continue to have similar variables that they can control, the mutual funds managers live in an entirely different universe. These mutual fund ratings have been analyzed to determine their predictive power and have been shown to be a poor indicator of future performance. Even Don Phillips – the President of Morningstar – acknowledged at a conference in 2010 that “the star rating is a grade on past performance. It’s an achievement test, an aptitude test….. We never claimed that they could picked the future.” Someone forgot to tell the investing public.
This is probably due to Morningstar placing the star rating at the beginning of each report and their use of the rating in heavy advertising. When Morningstar and the mutual fund companies’ advertises their high rating, they are trying to simplify their past performance as if it was a hotel rating. Investors should think twice about their value as a predictor of future performance.
So what is an investor to do? The best approach is to first determine what they are trying to achieve – with specificity. Once that is done, an investment portfolio can be developed using asset class investments. Asset class investing involves owning all of the publicly traded companies in a category such as large US companies. The portfolio would own each different asset class in the percentage that would be needed to achieve their long-term goals. The key is to focus on how particular asset classes have performed historically and not focus on the individual ratings of mutual funds. In doing so, you avoid the all too familiar problem people investing in highly rated mutual funds and then only being disappointed as the fund is downgraded later.
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