Mutual fund ratings not all they’re cracked up to be

December 03, 2012

Pensions & Investments

Whether an investor is a 401(k) plan sponsor or a participant, once any investor selects the asset classes in which they intend to invest, they face the difficult issue of selecting specific managers. A variety of methods have been used over time, but one method that seems to have captured the focus of many investors is that of the performance-based rating system.

A 2009 study by Advisor Perspectives evaluated the predictive ability of the Morningstar rating system. The study measured the probability that a randomly selected higher-rated fund will outperform a randomly selected lower-rated fund. The study’s organizers believed that this metric was the most meaningful way to assess the usefulness of the rating system. The firm evaluated the incremental improvement that they would obtain by, for example, trading up from a 4-star to a 5-star fund.

The study found that a one-star improvement across the five fund categories tested (U.S. equity funds, international funds, balanced funds, taxable bond funds, municipal bond funds) was 50.6%. Essentially a 50-50 chance whether a higher-rated fund would outperform a lower-rated fund.

In response to the study, Russel Kinnel, director of mutual fund research for Morningstar Inc., stated: “In short, the star rating is a backward-looking measure of past performance. What it is not is a forward-looking measure of fundamentals.”

In 2010, C. Thomas Howard, a professor at the Reiman School of Finance, University of Denver, confirmed Advisor Perspectives’ evaluation. Mr. Howard’s study evaluated the predictive power of the Morningstar weighted historical returns using a sample of all active U.S. equity mutual funds spanning the period from January 1980 through June 2008. He found that the fraction of the equity funds’ subsequent one-year return volatility explained by these weighted historical returns is .002 (i.e. r-squared). This essentially zero correlation is right in line with Advisor Perspective’s findings that star ratings are not predictive of performance.