By Jeffrey Meenes, CFP® (Published Date October 12, 2023)
Investors everywhere think a 5-star rating from Morningstar means a mutual fund will be a top performer—it doesn’t.
Morningstar, Inc. is a renowned mutual fund and exchange-traded fund (ETF) rating agency, highly regarded for its investment research. However, investors should exercise caution when relying solely on Morningstar ratings for making investment decisions.
How predictive are the Morningstar ratings? The Wall Street Journal found that only 12% of five-star funds earned that top rating over the subsequent five-year period. An embarrassing 10% of five-star funds were awarded only a single star five years later. Here's why:
Past Performance vs. Future Performance:
Morningstar's star rating system is primarily based on a fund's past performance relative to similar funds. This system doesn't account for outliers or managers having exceptionally good or bad years, which can distort trailing average performance. Therefore, it can't accurately predict future performance.
Late to the Party:
By the time a fund receives a five-star rating for past performances, it might be too late for investors to benefit fully from those returns. Morningstar and its followers often show up late to the party, potentially missing out on optimal investment opportunities.
Changing Ratings Over Time:
A study requested by The Wall Street Journal found that a significant percentage of five-star funds lost stars over a ten-year period. Only a small fraction of these funds retained their premium ratings, indicating that past performance doesn't guarantee future success.
Vanguard conducted an analysis that revealed star ratings weren't reliable predictors of fund performance when measured against a benchmark. Investors had less than a 50% chance of picking a fund that would outperform, regardless of its star rating at the time of selection.
Expense Ratios vs. Star Ratings:
Russel Kinnel, director of manager research at Morningstar, found that low-cost funds with lower expense ratios consistently outperformed high-cost funds. Expense ratios were more reliable indicators of future performance compared to star ratings.
In conclusion, Morningstar itself acknowledges that its rating system is a quantitative measure of past performance and not intended to predict future results accurately. While it can be a useful tool to evaluate a fund's track record compared to peers, investors should consider other factors, such as expense ratios and overall strategy, when making informed investment decisions.
This content is developed from sources believed to be providing accurate information, and provided by Meenes Wealth Partners. It may not be used for the purpose of avoiding any federal tax penalties. Please consult legal or tax professionals for specific information regarding your individual situation. The opinions expressed and material provided are for general information, and should not be considered a solicitation for the purchase or sale of any security.