Financial advisors know they need to do a lot more due diligence when choosing mutual funds for clients than relying on Morningstar mutual fund ratings — if they use the ratings at all.
The star ratings, based on past performance over the previous three, five and 10 years, are a look backward, with limited applicability to the future. Mutual funds say as much in their prospectuses: “Past performance does not guarantee future results.”
(Related: Active Funds Are Performing Better — for Now)
A recent Wall Street Journal investigation of Morningstar ratings shows just how relevant that statement is. The Journal studied the performance of thousands of mutual funds from 2003 on and found that only 6% to 14% of the funds retained those high ratings three, five and 10 years later even though those same highly rated funds attracted the biggest inflows.
Top-rated U.S. equity funds were among the bigger laggards. While 14% of five-star funds overall held that rating three years later, only 10% of U.S. equity funds did. The spread was even larger over 10 years. Fourteen percent of five-star funds retained that rating 10 years later compared with just 6% of U.S. equity funds.
Bond funds performed somewhat better. Sixteen percent of five-star taxable bond funds held five-star ratings five years later, but 8% saw their ratings drop to one star.
Despite these slippages in ratings, the Journal found that five star-rated funds “perform somewhat better than lower-rated funds on average.”
Morningstar responded to the Journal piece with several of its own, including a message from CEO Kunal Kapoor and articles (on its website) from Jeffrey Ptak, head of its global manager research, and Don Phillips, managing director. All three acknowledged the limitations of the star ratings and their value.
“What the Journal itself found is that while high-rated funds didn’t unerringly outperform over the decade that followed the rating, they were far more likely to succeed (defined as a subsequent 4- or 5-star rating) than low-rated funds,” wrote Ptak in a piece called “Setting the Record Straight on Our Fund Ratings.”
“Five-star funds succeeded about seven times more often than 1-star funds. Conversely, low-rated funds failed (defined as a subsequent 1- or 2-star rating, or that died through merger or liquidation) at a much higher rate than highly rated funds.”
He added that since Morningstar awards 5-star ratings to just 10% of funds, having 14% of those funds retain that rating three and 10 years later suggests that investors in these funds have increased their odds of owning a better performing fund by 40%.