Be Careful when Studying Mutual Fund Rating Systems
Windowofworld.com – Wherever you look, you’ll find a variety of mutual fund rating systems that each use a different approach. All of them are designed to sift through thousands of funds for the best.
But is there really such a thing? Does a high rating mean that the mutual fund will perform better in the future? Many people think so. A recent study showed that Morningstar, North America’s most recognizable grading system for funds, had a tremendous effect on fund sales. If Morningstar assigns a five star rating, the fund usually enjoys an increase in sales as a result.
While rating providers are careful to warn investors that their ratings do not tell the future, the star system is, unfortunately, used by some investors as if they were reading the Consumer Reports to buy a new drill. Proponents of the ranking approach argue that there is no subjective component to star ratings. It is not determined by analyst reviews, and cannot change simply because the service does not like the fund manager or his investment strategy. And that’s great.
Performance will vary. Mutual fund performance often falls and the level of risk increases over the next three years after the fund is given an initial five-star rating, suggested another recent study by Matthew Morey, a professor at Pace University. One reason is that after receiving a five-star rating, the size of the fund grew dramatically, which in turn made the fund difficult to manage, he advised. Since Morey’s study was completed, Morningstar has also changed the way it shares top rankings to be more precise. One of the biggest problems with all scoring systems is that they are not always predictive. This means they aren’t really set up to tell you whether a particular fund will be better off in the future. For the most part, the ratings show how much you might have made and how much aggravation you faced in the process.
Combines risk and profit. For example, one five-star mutual fund might post a moderate return score, but a very low risk score. Other five-star mutual funds may have a much higher risk score, but the return score can be strong enough to help it stay in the top 10% of the package.
In some cases, in fact, it’s not even the same fund to start with. Remember, after a change in management, the rating remains with mutual funds, not portfolio managers. Therefore, a mutual fund rating may be based almost entirely on the track record of a manager who no longer holds the mutual fund.
Understand how rankings are developed. Too many people stress results without knowing how they were achieved. If you’re going to use ratings, take some time to understand how ratings are developed and what they really mean. It’s not the destination but the journey that counts.
Past performance is not a guarantee of the future. You may have heard of this disclaimer a thousand times before, but it’s very important to understand. Most ranking systems have little or no predictive element in them. It’s natural to think that the best players of the past will be the best in the future. Unfortunately, it’s not that simple. Just think; If it were that easy, investors would continue to buy from last year’s winners knowing they would be this year’s winners. And it rarely works.
Ranking is a very important element in trying to differentiate between good and bad funds. Good research, however, is far from looking for five or an A + stars. When evaluating funds, look at the quantitative and measurable characteristics of the fund: returns to benchmarks, costs, risks, taxes, and the manager’s tenure. Use a scoring system as part of your research, but remember: just because analysts give them the highest rating, it doesn’t mean they’ll be the best investment of the future, and it doesn’t mean they’ll be the best investment for you at any given point. Take the time to understand how these rankings were achieved. This will be the first step to educating yourself about funding.