When I entered the world of Wall Street in 1990, the industry had one dominant source for rating the performance of mutual funds—Morningstar with its one to five star rating system. Reminds me of systems used to rate movies.
For the last 20 years, Morningstar’s ratings have been used by the vast majority of our nation’s financial advisors and by millions of investors to guide their mutual fund investment decisions. Almost all the pros recommended that their clients invest in the 4-5 star funds and about 90% of the money dutifully follows that advice.
The problem with the Morningstar system is that with rare exception, strong short term fund performance is meaningless since the majority of the 4-5 star funds drop to 3 stars or less within a few short years. When the performance and ratings drop, investors are advised to roll their money to the next set of 4-5 star funds. The result is both investment underperformance and additional losses from paying the substantial commissions required by the fund switch. This cycle is extremely damaging and yet is the norm.
The problem has been evident for a long time. About 12 years ago Morningstar itself went on record that people shouldn’t depend on their star rating when choosing a fund. Here is their official statement, followed by a couple of quotes from independent sources:
“If you ask us, star ratings are overrated.”
––Morningstar’s Fund Investor, February 1999 (Morningstar’s own newsletter)
“Despite the focus on the stars, there is scant evidence that the stars accurately identify future top-performing mutual funds . . . the results of the study suggest (that) the stars are not useful in identifying future top performers within asset classes.
––Journal of Investment Consulting
Probably the single most potentially dangerous action a mutual fund investor can take is to pay attention to “top performance” lists.
—John Markese, president, American Association of Individual Investors
Even after stating that their star system was “overrated” Morningstar did nothing to try to solve or change their rating system for another 12 years. Finally, about 6 weeks ago, Morningstar announced they were replacing their existing star rating system with a “new and better one”.
Let me state the obvious here. They got it wrong for a long time, 20 years, (12 years by their own admission) and by now it should be very clear that almost nobody can reliably beat the market.
As discussed in an earlier blog on index funds, the winning solution going forward is very clear and is something anyone can easily do. When the time is right to invest in the stock market, invest in no-load (no commission) index funds only. Since over 90% of managed mutual funds dramatically underperform the market and index funds directly mirror the overall market they represent, have no commissions and lower fees, you can be confident you’ve made the winning choice.
Should you have any lingering doubt whatsoever that index funds are the way to go, learn about the two huge studies that document what happened to the vast majority of the people that invested in the stock market from 1984-2004 . Avoid the damage these studies document from now on by choosing to put your stock investments in broad-based no load index funds.
With this strategy, the star rating game becomes irrelevant. And that’s a very good thing. Save star ratings for the movies (I hear the new Captain America movie is good) and see to it that the money you worked so very hard for is safely working for you.
(See, Morningstar Responds.)