The importance of a 5-star rating

The importance of a 5-star rating

It’s a rising star! Oh, the star just fades.

 

Go ahead and try taking a list of the top-rated mutual funds from Morningstar inc from just a few years ago and look at them now. It makes you reflect because many of the once-proud “rising star funds”, are now dropping from once being five stars rated to four stars, three stars, or even worse.

So what are the lessons to be learned from that?

 

What is the ‘Morningstar Risk Rating’?

“The Morningstar Risk Rating is a ranking given to publicly traded mutual funds and exchange-traded funds (ETF)s by the investment research firm Morningstar. The ratings range from one to five stars, with one being the poorest rank and five being the best. Morningstar’s risk ratings, also called star ratings, are designed to help investors quickly identify funds to consider for their portfolios.” — Investopedia

 

I suggest you read a very good analysis about the mutual funds and the Morningstar’s rating. Mr. Philips and Kinniry illustrate it well.

“In fact, our analysis reveals that higher-rated funds are no more likely to outperform a given benchmark than lower-rated funds and that the value of indexing stems in large part from low operating costs and the zero-sum game.” — Christopher B. Philips, CFA & Francis M. Kinniry Jr., CFA, “Mutual fund ratings and future performance”.

 

In their analysis, they focused on the Morningstar’s rating system and referred it to its actual performance predictability. They looked at costs as a potentially more meaningful metric for selecting investments versus indexing.

 

They conclude that if an investor is looking at a given star rating as his only decision fundamentals since most of the time an investor is focused on a short-term performance the potential of the exposed risk is big; the funds are more likely to underperform.

Even if the investor is in for the long run by considering who is the fund manager, the parent team and the cost, because of the uncertainty and the higher cost, an investor should turn to a more prudent approach as with an index fund.

 

“The stars are so important that mutual fund companies do not hesitate to eliminate funds that do not cross the threshold of 4 stars. During the five-year period ending in 2012, 27% of the US national equity funds and 23% of the international funds were merged or liquidated; it is a common practice to erase the disastrous roadmap of a given element within a fund family.” – David Swensen.

 

If you get curious you can subscribe for a 14 days’ free trial and explore the “Awarded Morningstar Funds”.

 

The Morningstar Rating is the most used referral system for investors but there are other rating creators: Standard and Poor’s, TheStreet, Zach’s Investment Research, Thomson Reuters Lipper, and some business and finance publications from US News and Forbes.

 

Have you watched the movie “The Big Short”? For many reasons this movie is a must see but it’s particularly stunning to understand what’s going on in the “real” life after having seen the scene when one of the main characters, Steve Carell is sitting in the office of Standard and Poor’s agency talking about the rating of the bonds. (1:05:00)

 

So, what do you think?

Are you ready to pick your 5-star winner?

 

 

– Make It Happen –

MAG

 

*Read more:

The Wall Street Journal
Investopedia
Christopher B. Philips, CFA & Francis M. Kinniry Jr., CFA

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